Net Present Value - NPV

As a concept, the net present value seeks to assign a total value for an asset that is expected to provide cash flow over a period of time. You have an asset that pays off a little at a time. What's that worth right now? What amount would be a fair price for it, if you were to try to sell it now? Net present value effectively answers those types of questions.

Calculating the net present value involves a good deal of expectation and assumption. It's a rigorous mathematical operation, but, since it involves the future, many of the variables are based on probabilities and educated guesses.

You loan your brother $1,000. He promises to pay you back over the next year, plus a good amount of interest. Under the deal, he'll give you $100 a month for each of the next 12 months. So, by the time the year is up, you'll have $1,200 back...your original $1,000 plus a $200 profit...a 20% return. The day after making the deal with your brother, your dog gets sick and needs an operation. Suddenly, you need that cash you handed over to your brother...except he's already spent it. Your sister steps in, offering to buy your brother's debt from you. She asks you to name a fair price.

Your sister is basically asking you to provide the net present value for that cash flow you expect from your brother. The deal promises to pay off $100 a month for the next 12 months...meaning it is theoretically worth $1,200.

But net present value gets more complicated than that. There are a bunch of factors at play. For one, your brother might not pay off the full amount. He may pay on time for five months, then give $50 in the sixth month, and finally stop answering texts in month number seven...by next year, he might be living under an assumed name, only sending coded messages to your mom via carrier pigeon. Also, you have to account for inflation. A 20% return in a year is pretty good. But if inflation eats away that return by three percentage points, suddenly the net return becomes 17%. Basically, a dollar right now is worth more than that same dollar in 12 months. $100 now might have the equivalent buying power of $97 by the end of the term.

Your brother is pretty reliable, but something could happen to him (for instance, he could catch the same thing your dog has and become incapacitated). You put the chance of default at 10%. Meanwhile, you project inflation will eat away about 3% of the value of cash flow as well. So $1,200 nominal value for the deal becomes $1,164 after inflation. Then the chance of default knocks another 10% off. That leaves you with a net present value for that loan to your brother of $1,047.60.

Real-life net present value equations can get even more complex. A lot of variables go into the calculations and, as we noted, it can involve some guesswork. That guesswork should be based on data and reasonable assumptions...but there is an element of the unknown inherent in the process.