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Lean Definition: Net Present Value

 

Net Present Value (NPV) comes from the principle that money today is worth more than money tomorrow.

Would you rather have $1,000 today or $1,000 in 5 years? That question is easy to answer. Most people would take the money immediately.

What about this one: Would you rather have $1,000 today or $1,537 in 5 years? That gets a little harder to answer.

The net present value of $1,000 in your hands right now is $1,000. But to compare it to the other value, you need to figure out what the $1,537 would be worth today.

There’s a moderately complex formula to determine the net present value of the future option. Once tomorrow’s money is converted back to today’s value, it can be compared to the cash in hand.

This is called ‘discounting’ money and requires applying a ‘discount rate’ to the net present value formula.

NPV is also an important part of calculating a company’s opportunity costs.

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