Cash flow diagrams are a tool for organizing and visualizing information about a specific investment, business opportunity, or engineering project. Drawing an accurate cash flow diagram helps financial analysts keep track of all the money flows that result from any decision. However, the goal of net present value analysis is to simplify all of the disparate information in the cash flow diagram into a single number: present value.
“Net” present value refers to the difference between all of the costs resulting from a project and all of the revenues, after each is discounted to present value. This video shows an example of a college student who is considering investing $10K they’ve save for college in equipment for a landscaping business. They make some assumptions about the cost of the equipment, the revenues they will receive from the business, and what they can sell the used equipment for. Lastly, to complete the analysis, they need to choose a discount rate that reflects their time preference. This could be the cost of borrowing the initial $10K investment, or it could be some other value.
This video uses Excel to show how the net present value changes with respect to changes in discount rate. Notice that Excel includes an “NPV” formula that saves the analyst the trouble of typing.
When an investment has positive net present value, then it is profitable. However, this doesn’t necessarily say much about whether this investment is more profitable than alternative investments, relative to amount invested. Another way to assess the quality of an investment opportunity is to calculate the internal rate of return (IRR).
The next video uses the same example, but instead of selecting a discount rate to calculate a net present value, we look for a discount rate that makes all the future revenues equivalent to the initial investment, which we call the IRR. Investment opportunities with higher IRR are preferable to lower.