Net Present Value explained in simple words
In one of my last posts (Agile-Giving the business options back) I promised a follow-up regarding Net Present Value (NPV). Here you go! This will be VERY basic, so if you’re familiar with the concept you might be seriously bored.
NPV is a financial appraisal method that can be universally applied, and is an extraordinary fit with agile product development. I’ll try to explain it in simple everyday language, even if this might be at the cost of some academic rigor. As a start, let’s break it into two parts: NET and PRESENT VALUE.
Lets’ start with Present Value: Assume you are presented with the following choices:
- Someone offers you to give you 100 EUR today.
- Someone offers you to give you 100 EUR one year from today.
How do you choose? Of course you’d pick option 1. If you get 100 EUR today, you can invest it, and in a year from now you might have 102 EUR if your investment has a modest return of 2%. In addition, inflation will eat off a few pieces of your 100 EUR bill – so in a year from now, the same bill might buy you only 97 EUR worth of goods. Generally, there is a preference to get money rather sooner than later, so you’d need some form of compensation to get the money later.
–> Present Value is today’s value of an amount of money in the future.
Now, let’s make it a bit harder. How about this choice:
- Someone offers you to give you 100 EUR today.
- Someone offers you to give you 105 EUR one year from today.
You get options like this often in every day life, for example fitness companies offering a discount if you pay your membership fees for two years in advance.
So, which option would you choose? Basically, you are offered a 5% mark-up that needs to reimburse you for the loss of investment (i.e. you can’t invest the 100 EUR in other projects that might give you a nice return), the risk involved (will this person have the liquidity to pay you the 105 EUR in a year from now), and the expected rate of inflation.
For you as a private person, let’s assume you could put the money in the bank and would receive 3% interest. Inflation is currently rather low, let’s expect 1.5%. The person is rich and trustworthy, so no worries about liquidity. With your 3% investment, you’d have 103 EUR in a year. Given 1.5% inflation, the 103 EUR would be worth only 101.46 EUR. So if you’d take the 100 EUR today, you’d have 101.46 EUR in a year. Option 2 would be favorable, as you would get 105 EUR! All these percentages you’re dealing with are combined into the ‘discount factor’.
Of course, there is a lot more to it mathematically, see Wikipedia.org on Present Value.
The simple version: Present Value = Future Value / (1 + discount factor) ^ years
Phew, so where does the NET come in?
Net Present Value is used to calculate the total of all cash flows (in and out) that can be directly linked to your project. If it is positive, good. Otherwise, you might reconsider the investment.
Here is how it works: First, you need to list all the cash inflows and outflows of your projects, sort by year.
Example: The initial cost of your project is 20,000 EUR in year 0, and additional 10,000 EUR in the years 1, 2 and 3. You assume that you will be able to generate cash inflows (for instance through subscriptions) from this project in the years 1-3 of 10,000 EUR each.
year 0: out: -20,000 EUR (initial project investment) year 1: out: -10,000 EUR (project support) year 1: in: +20,000 EUR (income generated from investment) year 1: net: +10,000 EUR years 2-3: see year 1 Assuming a discounting factor of 10% (0.10): year 0: PV = -20.000 EUR / (1+0.1)^0 = -20,000 EUR year 1: PV = 10.000 EUR / (1+0.1)^1 = 9,091 EUR year 2: PV = 10.000 EUR / (1+0.1)^2 = 8,264 EUR year 3: PV = 10.000 EUR / (1+0.1)^3 = 7,513 EUR
The resulting Net Present Value is the sum of the present values above:
NPV = -20.000 EUR + 9,091 EUR + 8,264 EUR + 7,513 EUR ----------------- NPV = 4,868 EUR =================
The NPV here is positive and therefore favorable. There are other non-financial and financial investment appraisal techniques available (such as Payback and IRR), but this is a good positive indicator.
Discussion: One thing you see: The later the income generated, the less it is worth (and of course, uncertainty increases the further you look into the future). If you wouldn’t have taken the time value of money into account (i.e. you would have used the un-discounted cash amounts instead of the Present Values), you would have gotten a project return of 10,000 EUR, which looks far more favorable than the ‘correct’ NPV. Please note that this model also has limitations and should not be used as the only appraisal technique.
And now we’re finally turning the corner back to agile – yeah! Imagine you’re running this project using Scrum, and after 6 months you’re already able to get a few subscriptions of your service sold, because you could release the product earlier (maybe with core functionality only, but customers still find it valuable). You could then have an early cash inflow in year 0 already of say 3,000 EUR which boosts your NPV up by exactly this amount from 4,868 EUR to 7,868 EUR.
Agile helps you to achieve cash inflows early. Because of the time value of money, these early cash inflows are a significant help for a financially healthy investment. (Plus, softer factors like reduced risk through early exposition, being earlier at the market, etc.)
Well, you can now put your calculator away again, or read further about this topic (for instance at Wikipedia). Good to know: Excel, Openoffice.org Calc & Co. have built-in NPV and IRR functions.
Although I left out a lot of details, I hope this was still useful. Let me know either way!