A few days ago I had an argument with my wife about whether I should pay my traffic violation ticket now or wait until I absolutely have to. In British Columbia (we have Communist-style-evil-monster-government-monopoly auto insurance) ICBC can deny insurance renewal until all outstanding penalties are paid. My renewal is not coming up for almost a year, and if I have to pay a penalty, I prefer to delay that moment for as long as I can. But my wife believes that a dollar is a dollar, and it is better to pay today. This argument has prompted me to write this article.
Net Present Value (NPV) is a basic financial planning concept which reflects the fact that a dollar today is not the same as a dollar tomorrow. Disagree? How about a dollar in ten years? Would you prefer to receive a certain amount today or the same amount in ten years? Most people would rather get the money now.

But NPV is not about when you need the money. It’s about the fact that money is almost never sitting hidden under a mattress – it is earning interest. If you are considering a $100 investment which will return $102 in a year, this may seem like a good idea unless you can get $104 by simply putting the money in a savings account. In other words, if you don’t do anything, your hundred dollars will turn into $104 in a year. Now, if we look at this example from another angle, we can say that $104 a year from now is the same as $100 today. And if we apply the proper financial term, the Net Present Value of $104 a year from now is $100, assuming a 4% discount rate.

NPV is especially important in evaluating the attractiveness of investment projects which are expected to generate different positive and negative cash flows in different years. Very often, investors expect this from a start-up business. For example, projected cash flows can look like this

Year 1 - $100,000 (Original investment):
Year 2: - $20,000
Year 3: - $5,000
Year 4: + $45,000
Year 5: + $80,000

This is a typical scenario of a successful start-up. In the first couple of years the business is striving to get going, the start-up costs drive the bottom line down and the cash flow is negative. But later the operating income picks up and we see some positive numbers. If you simply add the numbers above, you will get a zero and conclude that this project pays for itself in 5 years. But the negative outflows in this example happen in the early years while positive only in years four and five. If we assume the same 4% discount rate, the NPV of this project will be negative $15,033. This means that this project doesn’t pay for itself in five years. NPV is a very important common denominator which allows us to compare cash flows happening in different points in time.

The 4% discount rate is the one that has been used most often historically. Traditionally, the prevailing rate of return of a risk-free investment, such as government bonds, is used as a discount rate for NPV calculations. But in today’s low interest rate environment a lower number can be used.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.