Future Value, Present Value & Net Present Value
When making financial decisions, understanding concepts like Future Value (FV), Present Value (PV), and Net Present Value (NPV) is crucial. These concepts help investors and businesses assess the value of investments over time, considering factors like interest rates and discounting. In this blog, we’ll break down these financial concepts with simple explanations and examples.
1. What is Future Value (FV)?
Future Value (FV) is the amount an investment grows to over time at a given interest rate. It helps answer questions like, "How much will my investment be worth in the future?"
Example:
If you invest $100 at an 8% annual interest rate, the future value after 5 years can be calculated as:
FV = PV × (1 + r)^n
= 100 × (1.08)^5
= 100 × 1.4693
= $146.93
This means your $100 investment will grow to $146.93 in 5 years.
Key Takeaways:
✔ Future Value grows over time due to compounding.
✔ A higher interest rate leads to a higher FV.
✔ Longer investment periods increase FV.
2. What is Present Value (PV)?
Present Value (PV) is the current worth of a future sum of money discounted at a specific rate. It helps answer questions like, "How much is $100 received in 5 years worth today?"
Example:
If you will receive $100 in 5 years, and the discount rate is 8%, the present value can be calculated as:
PV = FV ÷ (1 + r)^n
= 100 ÷ (1.08)^5
= 100 ÷ 1.4693
= $68.30
This means $100 received in 5 years is worth $68.30 today.
Key Takeaways:
✔ Present Value represents today’s worth of future cash flows.
✔ A higher discount rate reduces PV.
✔ PV helps compare investment opportunities fairly.
3. What is Net Present Value (NPV)?
Net Present Value (NPV) is the difference between the present value of cash inflows and cash outflows. It is widely used to evaluate investment decisions.
Decision Criteria for NPV:
✅ If NPV > 0: Accept the project (Profitable)
❌ If NPV < 0: Reject the project (Not profitable)
➖ If NPV = 0: The project breaks even (Consider other factors)
Example:
Suppose an IT project requires an investment of $400,000 and will generate cash inflows as follows:
- Year 1: $70,000
- Year 2: $120,000
- Year 3: $140,000
- Year 4: $140,000
- Year 5: $40,000
With a discount rate of 8%, the present value of all cash inflows is $408,959. Since this is greater than the initial investment, the NPV is positive ($8,959), meaning the project is profitable and should be accepted.
Key Points:
✔ A positive NPV means a project is profitable and should be accepted.
✔ A higher discount rate lowers NPV.
✔ NPV is crucial for making investment decisions.
Understanding FV, PV, and NPV helps investors make informed financial decisions.
📌 Remember:
✔ Future Value (FV) increases over time with compounding.
✔ Present Value (PV) decreases as the discount rate increases.
✔ Net Present Value (NPV) should be positive for a project to be accepted.
✔ Higher discount rates lower both PV and NPV.
✔ NPV and IRR together determine the financial viability of a project.
