FINANCIAL TOOL
Net Present Value
When considering different paths you could take for that next step of adventure, you may find it useful to think about your actions in terms of Net Present Value.
This number helps you determine whether an action is likely to improve your financial situation.
An example may be more helpful than the definition.
Imagine this:
- You have $100,000 and are considering how to invest.
- You believe you could invest it passively in the stock market and average an estimated 8% over the next ten years.
- But you also have the opportunity to buy a small business that makes an estimated profit of $30,000 per year.
If you don’t have time to run a small business, then the answer seems clear: the passive stock market is the better choice in terms of time required from you.
But if you do have capacity to run a small business, then here’s another way to look at this opportunity.
Let’s say you also estimate that once you acquire the business, you believe you can run the business for the next ten years. To keep things simple, perhaps you believe you can increase profits 50% after the first two years and then hold steady for the next eight. Then you plan to sell the business for the same multiple that you bought it for.
Is this a good deal for you?
That’s where Net Present Value comes in. And you’ll need a financial calculator to find it. If you don’t have one, you can use a free app such as BA Financial Calculator on Google Play or BA Financial Calculator for iPhone.
Once the calculator is on, follow these steps:
- Press CF to display CF0 (which means the first cash flow out)
- Type -100,000 and click Enter (make sure to include the negative sign)
- Press the down arrow (you should then see C01 which means cash flow 1)
- Type 30,000 and press Enter and down arrow (you should then see F01 which means frequency 1)
- Type 2 and press Enter and down arrow (this means you expect $30k profit for the first 2 years)
- For C02, type 45,000 and press Enter and down arrow (you’ve improved the profit)
- For F02, type 8 and press Enter and down arrow (assuming you make this for the following 8 years)
- For C03, type 150,000 and press Enter and down arrow (you sell the business in year 11 for this final inflow of cash)
- For F03, type 1 and press Enter
- Press NPV (right next to the CF button)
- Type 8 and press Enter (this is the 8% which you believe you could make on the stock market as an alternative with this money)
- Press the down arrow.
- Press CPT (stands for “compute” in the upper left-hand corner)
This will calculate the Net Present Value as $239,537.
What does this number mean? It means that buying the business, under these assumptions, is offering you the same value as having an additional $239,537 in your pocket today.
Actually, any positive number for NPV means that it’s a valuable action to take.
When making a big decision, you may also want to run a scenario that you think would be close to worst case. This can also be helpful to determine the risk you’re taking and whether you still think it’s worthwhile.