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Net Present Value

# Net Present Value - Net Present Value(NPV Decisions on...

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Net Present Value (NPV) Decisions on capital outlays are among the most significant a firm has to make. A decision to build a new plant or expand into a foreign market may influence the performance of the firm for many years. Companies need quantitative models to help them decide whether a proposed project will provide a profit or not over the long term. Net present value is one of the most commonly used tools for making capital budgeting decisions. Money has a “time value.” A dollar received today is not equal in value to a dollar received in a year. Why? Because of interest rates. If I have a dollar today, I can put it in the bank and earn, let’s say 10%. In a year, my dollar would have grown in value to \$1.10 (\$1 times 1 plus the interest rate = \$1 x 1.1 = \$1.10). We call the \$1 that I have now the “Present value” and the \$1.10 that it will grow to in a year the “Future value.” Net present value (NPV) operates the same way. The company first estimates the profits that they expect to make in each year from an investment. Then it finds the present value of each amount. To use a simple example, if it expects to make \$1.10 on the investment next year, then it calculates to find what amount in the present is equivalent. At a 10% interest rate, the present value of \$1.10 to be received a year from today is \$1. Translating that future amount of \$1.10 into a present amount of \$1.00 is called discounting. The 10% interest rate is called the discount rate.

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