Friday, May 1, 2009

Net Present Value

It's time that I start talking more about finance topics, since that is the name of the blog, after all...

Net Present Value or NPV for short is the value TODAY of a series of cash flows over time.

So for instance:

If you are getting 5,000$ a year for the next 3 years cause you won the mini-lotto. It would be wrong to assume that the value of the cash you are getting is 15,000$ (5,000$ times three), since the value of cash goes down with time (otherwise known as inflation).

If we took a discount value of 2% (the same as inflation), then the this year's 5000$ would be the same 5,000$ today, next years 5,000$ would actually just be the same as 4,901$ today (5,000$ divided by 1.02), and the 5000$ the following year would be only worth 4,805$ today (5,000$ divided by 1.02 and then divided again by 1.02)

In this example the discount rate it only equal to inflation, but in other cases it can be much greater, since you can make the discount rate the same value as the % you would be able to get in the stock market for instance, since this is money that you are not getting now and can't invest with it, and hence there's a penalty associated to it.

This is an extremely important topic in finance. One of my project managers at work was telling me that it was a very important concept in their Project Manegement Certificaion (PMP - project management professional), since a lot of projects are based on the time value of money over several years. This becomes a really important point when the projects are in the millions of dollars.

Lessons Learned:
1. Talk about NPV in your next team meeting, and you will look smart

2. Invest your money TODAY and start saving (like the ING Direct guy says in those funny commercials), since you lose money every year by NOT MAKING any money. Put 10,000$ under your bed today, come back 30 years later, your money has the buying power of only 5,000$ due to inflation!!!!!

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