Net present value calculations take a certain dollar amount from a future period and discount the dollars to a current period value.
Net present value calculations take a certain dollar amount from a future period and discount the dollars to a current period value. To do this correctly, individuals must use an interest rate for the formula. A common interest used is a company’s cost of capital, which is the rate paid on borrowed money, whether debt or equity. Therefore, there is a direct connection between the cost of capital and the NPV. Companies can use various cost of capital ratios to fully examine a potential project using the NPV formula.
In business, decision making is often one of the most important – and most difficult – activities a company’s management team engages in. Almost all companies make decisions where looking at the financial return is a significant part of the process. The problem with looking at future financial returns is that a dollar tomorrow is not worth the same as a dollar today. There are many different reasons for this difference, although inflation and other economic factors are among the most common. To make a dollar-to-dollar comparison, it is important to discount future dollars back to their present value using the formula for cost of capital and NPV.
The cost of capital and NPV formula is often the most important tool used to make dollar-to-dollar comparisons when making decisions. A basic formula for this process multiplies the future dollar value of a given period by the cost of capital, the latter being divided by one plus the interest rate, raised to the cash flow period. The result is a lower dollar value that the company can compare to the initial cash outlay for a given project. If a project has multiple cash flows over multiple years, the company will need to repeat this formula for each year, changing the formula to reflect the number of years. Changes may be necessary, although a company’s leaders need to make that decision about the formula.
Using a cost of capital and NPV formula has its flaws, which can lead to disastrous results. For example, poor estimates of future cash flows can result in less funds received from a project. An inadequate capital cost formula can also lead to poor results; this is an especially important consideration as the cost of capital and NPV formula require precision to produce solid results. In some cases, this is why a company uses multiple cost of capital rates. Each rate can provide a low, medium and high perspective, giving the company more information about the bottom line cash flow from a project.