What is Net Present Value (NPV)?

Net Present Value is the single most important tool in your toolkit for evaluating and valuing commercial real estate. It forms the basis for other measurements, in particular the Internal Rate of Return (IRR).

The NPV of an investment is the Present Value (PV) of the expected cash flows created by that property less the PV of the amount invested. For example, the NPV over ten years for a property that you buy for $1,000,000 is the sum of the Present Values (PV) of those expected net cash flows generated by the property for each of those ten years less $1,000,000, the Present Value of the purchase price.

Present Value (PV) is the value of something discounted, or reduced, for the purposes of time. To gain an intuition for this, consider how you feel about receiving repayment on a $1,000 no interest loan to your friend tomorrow versus next year. You’d probably prefer, all else equal, to be repaid sooner than later because you perceive the $1,000 to be less valuable a year from now than $1,000 in twenty-four hours time. If you probe that feeling, you’ll probably conclude that if you have to wait a year to get repaid you’ll need to give up a year’s worth of opportunities to spend or invest that money.

There is an opportunity cost, therefore, to not having money in hand. That is what is referred to as the opportunity cost of money and the purpose of discounted cash flow analysis is to determine how much to discount one’s future expected cash flows for incurring that opportunity cost. The sum of these discounted cash flows is the Present Value (PV) of the investment. If you subtract the invested amount from the Present Value (PV), you’re left with Net Present Value (NPV).

Let’s take a look at the calculation in notation terms:

Don’t let the notation scare you off, it’s simple. First, some notes on Microsoft Excel notation: the symbol “/” refers to division; “^” refers to a power, such as 2^3 = 8, or 2 to the 3rd power is equal to 8. The other notation is simple as well; “+CF(1)” simply refers to the positive cash flow in year 1 and “-Inv.” refers to the negative investment amount, usually the price you paid for the investment/property.

The Net Present Value (NPV) in the last last line can be found by summing all the present value cash flows; the negative investment plus the present value of each cash flow for each year gives you the Net Present Value (NPV). Another way to say this is the total sum for the present values of all cash flows less the investment amount is the Net Present Value (NPV). Let’s look at an example using numbers:

Investments with a zero or positive NPV are attractive as they clear the “hurdle” established by the discount rate – those with positive NPV clear the hurdle with room to spare. Investments with a negative NPV are not attractive as the return on that investment is too small to get over that hurdle. Zero NPV is the point of indifference, technically, but in practice a zero NPV is the threshold at which you make the investment.

So our example above would be a winner an we would want to make this investment. Remember, anything investment with a zero or positive Net Present Value (NPV) is an investment we would want to make as it generates wealth above and beyond our cost of capital.

Comments on this entry are closed.

{ 4 trackbacks }