One of the main drawbacks of some investment value calculations is that they don’t factor in the time value of money. The time value of money is important because money today is worth more than money tomorrow.
The value of money decreases over time, so a sum of money is worth more now than the same sum will be at a future date. This phenomenon is due to money’s earnings potential in the interim, so items that cost $100 10 years ago might cost closer to $118 today. It is important to invest money in order to not lose value to inflation, risk, and opportunity cost.
When comparing net present value (NPV) versus present value (PV), note that they are both valuation calculations, each using a form of discounted cash flows to estimate the value of an income. However, these formulas differ in what factors they account for in the calculation.
In general, the value of the revenue you can earn today is more than the revenue you can earn in the future. Real estate investors use this principle to discount future income according to the investment’s expected rate of return. PV and NPV are useful for capital budgeting, as they help you understand which investments will yield the greatest return.
How to Calculate Present Value
Present value is the current value of a stream of cash flows or sum of money based on a certain rate of return. This calculation helps investors determine the current value of future revenue, or what rate of return they would need to have a specific amount of money later.
The PV formula considers a future amount of money and discounts it to present-day value. The formula is:
PV = FV/(1+r)n
With this formula, you can fill in:
- FV: Future value
- r: Required rate of return
- n: Number of compounding periods
If you input a high required rate of return, or interest rate, into the formula, the current value of a future cash flow decreases. This is because a higher interest rate means that the cost of borrowing money increases. This rate also improves the opportunity cost of investing money.
For example, suppose you have the option to receive $1,000 five years from now. If the discount rate is 5%, the present value of that future cash flow would be $783.53. However, if the discount rate is 10%, the present value of the same future cash flow would be only $620.92.
It is important to realize that the value of a dollar will change over time so that when you evaluate a potential investment, you can compare future income dollars at an equal value to the initially invested dollars. One investment valuation method that will take the time value of money into consideration is NPV.
How to Calculate Net Present Value
Net present value is used to determine the value of an investment by comparing the PV of expected cash inflows with the PV of expected cash outflows over a period. This calculation takes into account the time value of money.
As a result, the net present value calculation determines the potential profitability of an investment property. If the formula yields a positive NPV, the real estate property’s earnings are higher than the discount rate.
NPV is a calculation that will consider the time value of money to tell investors the present value of the potential net income throughout the course of the investment. NPV finds the present value of all future income and expenses, adds those together to find the present value of the investment’s total future cash flow, and then subtracts the initial investment amount to determine the present value of the total expected gain or loss on the investment.
The NPV formula is:
NPV = cash flow/(1+i)t-initial investment
In this formula, you can fill in:
- i: Required rate of return
- t: Number of periods
For example, if a property was purchased for $500,000 and earned a $50,000 net income every year for three years and then had a net income of $550,000 after selling the property in the fourth year, using an 8% discount rate, the investment would have an NPV of $33,136. The NPV formula for this example is:
33136 = 550000/(1+0.08)4-500000
PV vs. NPV: Key Differences
Present value and net present value differ in their:
- Calculation values: While NPV measures an investment’s value to determine potential profitability, PV measures the value of future cash flows in today’s dollars.
- Wealth creation: PV is an absolute figure that does not consider the additional wealth the investment may create. NPV calculates the potential profit of an investment.
- Cash flow: NPV subtracts cash outflow from cash inflow, and PV calculates the current value of a cash inflow.
Learn More About PV and NPV With 1031 Crowdfunding
Present value and net present value are complex calculations, and depending on your specific circumstances, you should consult with an expert as it relates to a given investment.
1031 Crowdfunding provides alternative investment vehicles to help our clients make strategic decisions with real estate investments. Discuss your investment options by contacting our team today.
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