Friday, March 9, 2012

Net Present Value

Today I impart the most important takeaway ever from Finance or Financial Management.  Always do a project if the Net Present Value is positive. It represents the culmination of a project cost calculation that includes the time value of money and the likelihood of different outcomes, and spits out a value for the project that you can use to objectively compare it to other projects (if you have limited funds).

Net Present Value (NPV) is a financial calculation used to determine whether to pursue a project.  NPV takes into account everything (if possible) about the project.  You need to quantify reward and financial outlay, of course.  But you also need to consider the risk of a project not meeting your projections.  In a simplified example, if you have a 50% chance to win $1 million and a 50% chance to lose $1 million, rationally, the chance would be worth exactly $0.   That evaluation needs to be done with a person's risk tolerance in mind, too.  While rationally that chance is worth nothing, a someone with a high risk tolerance may believe that the possible reward is worth the possible loss.

All financial projections have flaws.  I learned about several of them.  But the model with the LEAST flaws is NPV.  This calculation is the way a numbers-oriented manager chooses new projects.  There are underlying assumptions that must be stated when doing the calculation, but if you only make conservative assumptions, the calculation is defensible and persuasive.

No comments:

Post a Comment