Understanding Net Present Value as a Measure of Future Cash Flows

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Net Present Value

An investment that is expected to have a zero return is not a wise financial decision. With a return of zero, it would be better if the money were not invested at all. However, one measure of investment worth measures the cost of the investment in comparison to its expected future cash flows. Net Present Value is a method used to assess the worth of an investment in comparison to the risk associated with the expected cash flows.

The present value of an asset is a measure of the asset’s worth at time zero, or the time at which the asset is valued. However, taking into account the cost of the asset, the Net Present Value is the difference between what an asset is worth and what it costs. This relationship can be expressed as:

Net Present Value = Present Value of All Future Cash Flows – Cost of the Asset

An asset with a positive Net Present Value is expected to bring wealth to its owner because it is worth more than it costs. Of course, since the present value is based on expected cash flows, there is no guarantee that it will bring wealth. An asset with a negative Net Present Value would not be purchased because the asset costs more than it is worth. This would be like buying a car for $20,000 when it has a sticker price of $18,000.

The problem many novice investors have occurs when the Net Present Value of an asset is zero. A Net Present Value of zero simply means that the asset is worth what it costs. In other words, given the risk of realizing the expected future cash flows of the asset, the price is perfectly in line with the risk. An asset with a Net Present Value of zero is expected to create wealth equal to the risk associated with purchasing the asset; it is a fair investment.

When making financial decisions, it is important to choose only assets with a Net Present Value of zero or higher otherwise the investor is bearing too much risk given the expected future cash flows. For example, suppose an investment is expected to return $1,000 per year for 5 years at 10%. What is the maximum cost an investor should consider paying for the asset? First, an investor must calculate the present value of the future cash flows. It turns out the present value of the asset is approximately $3,791. A price above this figure, say $4,000, would make the Net Present Value negative,

$3,791 – $4,000 = – $209

A price below $3,791 would make the Net Present Value positive so the investor should buy the asset. A price of exactly $3,791 means that the price is perfectly fair since the price is exactly equally to the discounted value of the expected future cash flows.

The concept of buying assets either for a fair price or for a price less than what the asset is worth is a simple concept. However, Net Present Value often gives novice investors trouble because a value of zero simply means that the price of an asset is fair. A Net Present Value of zero means the investor is expected to receive a return appropriate for the amount of risk taken on. It does not mean that the investor is expected to realize a zero return.