What is net present value?

Definition

Net present value is the value today of cash you expect later, minus what you pay now. On the books, this is a decision reading, not a ledger account you debit and not a printed line on the Income Statement.

A print shop uses it when a press would send extra cash in over several years. A dollar next year is worth less than a dollar in the till today, so those later amounts have to be brought back before you subtract the outlay.

It is not a Balance Sheet line. The books will hold the press if you buy it; this reading is the test you run before that purchase.

Stay with today's leftover when you read it. Adding the later cash at face value skips the wait, and that is a different question.

Where it shows up

Cash flow: Related to future cash, brought back to today.

P&L: Related to later profit, which this number is not.

Balance Sheet: Related to the asset you would put on if you buy.

See also: Return On Investment · Capital Budget · Cash Flow Forecast

When you look at your Income Statement, this leftover is not a printed account. Later depreciation expense and later revenue will show up if you buy; this reading is not those later lines.

When the leftover is positive, the later cash, brought back to today, more than covers the outlay. When it is negative, you would be better off keeping the cash or putting it somewhere else.

The Balance Sheet does not print this leftover. The press would sit in fixed assets only after you buy.

On the Statement of Cash Flows, paying for the press and collecting the extra jobs are the cash events. This leftover is a forecast reading, not a posted cash total.

How it works

Write down the cash you would pay today. Then write the extra cash you expect in each later year, not the later profit line.

Bring each later amount back at a rate that stands in for the wait and the risk. A common teaching rate is 10 percent: next year's dollar is worth about ninety cents today.

Add those brought-back amounts. Subtract the cash you would pay today.

A leftover above zero means the later cash, in today's terms, more than covers the outlay. A leftover below zero means the wait costs more than the extra cash is worth.

Stay with cash when you do this math. Later profit can look fine while the shop is still waiting on invoices or still paying for the press.

Do not treat the face-value total of later cash as this leftover. Three years of $6,000 is $18,000 on paper; that $18,000 is not worth $18,000 today.

Return on investment states leftover against cost as a percent, without bringing later cash back. This page stays on today's leftover after the wait.

Example

Harbor Press, a print shop, is looking at a $15,000 press. It expects $6,000 of extra cash in each of the next three years from jobs the old machine cannot take.

A dollar later is worth less than a dollar now, so those three $6,000 amounts have to be brought back at a rate. Using 10 percent, the three inflows come back to about $14,920.

Subtract the $15,000 paid today. The leftover is about $80 on the minus side.

Face value said $18,000 in versus $15,000 out, which looks like a yes. After the wait, the press does not quite cover the outlay.

That leftover is not a promise of cash in the till, and it is not a profit line on the Income Statement.

If the extra cash were $6,500 a year, the same 10 percent wait would flip to a small plus. If it were only $5,000 a year, the minus would be larger.

A higher rate, if the shop needed the cash back faster, would also pull the leftover down.

Harbor Press does not post a line that says this leftover. The books post the press if they buy it; the reading is the test they run first.

Common mix-ups

This leftover is not the same as return on investment. That rate compares leftover to cost as a percent and does not bring later cash back to today.

This leftover is not the same as how long the press takes to return its cost in cash. That clock is payback period, which ignores the wait inside each later dollar.

This leftover is not later profit. Profit can include charges that never moved cash, and it does not by itself tell you what those later dollars are worth today.

Related terms

• Return On Investment: The gain from an investment measured against its cost.
• Payback Period: How long it takes an investment to return its own cost in cash.
• Capital Budget: The plan for major asset purchases over a period.
• Capital Expenditures: Spending to buy or improve long-lived assets.
• Cash Flow Forecast: A forward projection of cash receipts and payments.
• Sensitivity Analysis: Testing how much the outcome changes when one assumption moves.
• Free Cash Flow: Operating cash flow left after the capital spending needed to keep running.
• Scenario Planning: Modeling several plausible futures to see how the numbers hold up.