Discounting Model of Net Present Value

What is the discounting model of net present value

Well net present value is simply the present value of future payments or money that will

be received in the future. The idea is this, over time money becomes less valuable for a number of reasons

Also if you had received money, the same amount of money that you'll receive in the future

now, you would have alternatives to do with it to make money

So if you're going to receive money in the future, at points and times in the future

you need to understand what that money is worth in today's value as if you were to receive

it now. And there's a simple way of doing that to understand that money received one year for

now for example is actually the present value of that is this and it's based upon a discount factor

The way we do it is simply this. We identify the future cash flow. We divide that cash flow by a discount factor and that tells us what the present value of

that cash flow is. And if you have multiple periods of time, you can do that for each cash flow during

those periods and bring it back and understand it as what is the present value or net present value

So here's the formula that applies in this situation. Net present value equals cash flow and the end, the C is the cash flow and the end is

the time period, okay? That collectively, the summation of those divided by the discount

factor which is the interest rate that you're applying, so if you say that money will be

worth 5 less next year than it is this year okay You would say well 1 plus 0 right And then you raise that to the power of whatever period it is the first period the

second period. The reason you'd raise it to that power, one year from now, it would just be the cashflow

divided by 1 plus the interest rate. Over two periods though, what you've identified is the change in value or the percentage change

in value for each consecutive cash flow period, right? So in this formula, you can see, right

The first cash flow is present value. The cash flow one year from now, C1, that cash flow will need to be divided by the discount

rate for that one period, okay? It's raised to the one, so it's one plus in our scenario, 1.05%

You divide that and add it two, that brings it back to present value

Now you have another, a future cash flow number, in this case C2 which would be two years later

but it's your actual third cash flow. You would divide that by your discount rate raised to the second power and what that is

that recognizes that the compounding that you need to do that basically the 5% needs

to be compounded over two periods. You can't simply add them together and say 5% plus 5% is 10% because once again, the compounding

factor doesn't work that way. That's the topic for another discussion. But just to understand that this is how it works, you add up the value of these future

discounted cash flows and that brings it back to an understanding of what is your present

value, your NPV net present value. Thank you