Most people in finance have heard of Net Present Value or NPV, however most small business owners either have not heard of it or have no clue on how to use it. While it may sound like a very complex tool used for multinationals to uses during mergers and acquisitions that isn't all it is used for.
Calculating NPV is actually very simple and should be done by all businesses no matter what their size. For every decision involving cash outflow NPV can help you make the right one. The logic behind it is that money loses value over time (Time value of money) because of inflation and opportunity cost. If you had the money today you could invest it and earn more so you would rather have the money today instead of 5 years from now. This concept is important when making capital budgeting decisions. For example:
You are considering buying a piece of equipment for $10,000 that will save you $2500 a year on labor for the next 5 years when you will have to replace the equipment. Looking at this as simple math it would appear to be a good deal. $2500 of savings times 5 years equals $12,500 which is $2,500 over the $10,000 investment. However, the $10,000 outflow comes today and the inflows take many years to come in. Using a 10% discount rate the NPV of the project is actually -$523.03 and should be rejected. All negative NPVs should be avoided.
This simple example shows how using NPV even in seemingly obvious situations is a good tool to make the proper decisions. To calculate NPV you can use a spreadsheet or the built in finance tool that is free for all Protodea members.
