馃攳
Why You Need to know the Time Value of Money Formula (Excel NPV) - YouTube
Channel: Leila Gharani
[0]
A dollar today is worth
more than $1 tomorrow.
[3]
I'm sure you heard that one before.
[5]
This is true for any business,
[7]
but also for your own personal finance.
[11]
It's a simple principle
that has a fancy name,
[14]
the time value of money.
[16]
For example, you're selling your product
[19]
for, let's say $10,000.
[21]
One day your customer asks you,
[23]
if instead of paying the
$10,000 in cash right now,
[28]
that he can pay $10,800 in
equal payments over four years.
[34]
What would you say?
[36]
What's better for you?
[37]
Let's find out.
[38]
(upbeat music)
[42]
Before we get started,
[43]
a brief thanks to Skillshare
for sponsoring today's video.
[47]
Skillshare is a learning platform
[49]
with lots of great courses,
[51]
but I'm going to chat more
about them towards the end,
[54]
you're going to find a link as well
[55]
in the description of the video.
[58]
So intuitively, you'll know
[60]
that if someone promised you
$1,000 now, it's a better deal,
[65]
than let's say getting the
$1,000 in 10 years, right?
[70]
But why is that?
[72]
Well, for one,
[74]
money has an earning capacity.
[76]
So you could take the $1,000,
[79]
and you could invest it, and
hopefully make more out of it.
[83]
So there may be some lost opportunity
[86]
to make an additional income.
[88]
Also, money loses value,
[90]
because prices are increasing over time.
[93]
That's called inflation.
[95]
And finally, there is a risk factor,
[98]
who knows what's going
to happen like 10 years?
[101]
Will you really get the money then?
[104]
There's also that
uncertainty factor involved.
[108]
The combination of the factors
[110]
defines the time value of money,
[112]
and is usually expressed as a
percentage, a discount rate.
[117]
This discount rate is always specific
[120]
to your specific situation.
[122]
So, my discount rate may be
higher or lower than yours,
[126]
depending on how we
think these three factors
[130]
are going to impact us
in the coming years.
[133]
One is, are your opportunity costs high?
[136]
Because you know of this
other great investment
[139]
that you could do instead.
[142]
Do you think inflation will
be 2%, 5%, or even higher?
[147]
And there it is,
[148]
do you think the risk of not
getting paid is high or low?
[152]
Also, the further into
future the payments are,
[155]
the more opportunity cost, inflation,
[157]
and risk you're going to have.
[159]
That takes away from the value.
[161]
So when you're comparing alternatives,
[164]
always consider the timing
[166]
of when the payments are going to happen.
[169]
So, let's come back to
my initial question,
[172]
is it better to get the $10,000 today,
[174]
or get $10,800 over four years.
[178]
So in order to answer that,
[181]
we need to compare the
value of both options
[184]
at the same point in time, meaning today.
[187]
In other words,
[188]
we need to calculate
today's or the present value
[192]
of the future payments of the $10, 800.
[196]
So let's switch to
Excel, and check it out.
[199]
So here are our two options.
[201]
Year zero represents today,
[203]
one means one year from now, and so on.
[206]
The undiscounted total of $10,800,
[210]
is obviously higher than
the alternative $10,000 now,
[214]
By undiscounted, I mean
that the time value of money
[217]
isn't considered here.
[219]
It's just adding up the payments
[221]
that we're going to be
receiving in the future.
[223]
Because payments in the
future have less value
[227]
than an equal payment today,
[229]
we need to discount them.
[231]
Basically we need to reduce them
[233]
to get the present value
for these payments.
[236]
What is $2,700 worth to us right now?
[241]
Let's assume our discount rate is 5%.
[244]
This essentially means that
in each successive year,
[248]
the same amount of money is
going to be worth 5% less
[252]
than in the previous year.
[254]
It's like the opposite of
earning interest on a deposit,
[258]
instead of increasing the value,
[260]
it's decreasing, the value is worth less.
[264]
Let's calculate for year one first.
[267]
What 2,700 is worth to us right now,
[271]
basically, what is its present value?
[273]
First, I'm going to do this
manually using a simple formula.
[278]
And then we're actually going
to use an Excel function,
[280]
to do this whole calculation for us.
[283]
The manual approach,
[284]
helps us understand the underlying engine,
[287]
behind this formula,
behind the calculation.
[290]
To calculate what this
amount is worth to us now,
[293]
we're going to take this number the 2,700,
[297]
and we're going to divide it
by one plus the discount rate,
[302]
close the bracket, press Enter.
[303]
Now, you might be wondering,
[305]
why are we dividing this?
[308]
That's because we're moving backwards.
[310]
We're going from the
future down to the present.
[313]
If we were going forward,
[314]
so let's assume this
is our starting money,
[317]
I'm going to put this money in the bank,
[319]
the bank is going to give
me 5% interest on this.
[322]
How much is this money in one year?
[325]
The answer should be this, right.
[327]
So let's do the calculation.
[328]
It's going to be this number.
[330]
Instead of dividing, I need to multiply,
[333]
because I'm going into the future.
[335]
So I'm going to multiply
this with one plus,
[339]
this time it's the interest rate here,
[341]
close bracket, press
enter, and I get my value.
[344]
One thing you need to remember,
[345]
if you're going backwards from
the future to the present,
[348]
you need to divide.
[349]
If you're going into the
future, you need to multiply.
[352]
Now if you use the same concept,
[354]
and calculate the amount
for the second year,
[357]
we have to change our basis,
[359]
because our basis is now this.
[362]
So we're going to take
this divided by one,
[365]
plus the discount rate
and I'm going to fix it,
[368]
because I want to pull this across here.
[371]
You can see that as the years go by,
[374]
our 2,700 is worth a lot less,
the amount keeps decreasing.
[380]
Now, another way of writing this,
[382]
or a simpler way of writing this,
[384]
is to use the present
value formula right here.
[388]
PV stands for present value,
[390]
CF is the payment in the
future is our cash flow.
[393]
In the denominator, we
have the discount rate,
[396]
that's the r, so that's
our rate right here.
[399]
And n stands for the
number of years from now,
[403]
which we're going to receive the payment.
[406]
So it's just another way
of writing the formula
[408]
that we just wrote.
[410]
It's pretty much the same,
[411]
so it's going to take this value,
[413]
divide it by one plus our discount rate,
[417]
and I'm going to fix this,
[418]
but just so that we don't
have to reference back
[421]
to the previous year,
[422]
we can take this to the power
of the period right here.
[427]
So you need to find this operator.
[430]
And if you can't find it,
[431]
you can also use the
power function in Excel.
[435]
So with that, I'm going to press enter,
[438]
and drag this across,
[440]
and we get the same
numbers like we did before.
[444]
Okay, so this is just two different ways
[446]
of doing this manual calculation.
[448]
Okay, I'm just going to remove this one.
[451]
Let's just sum these up
to see what we get, 9,574.
[456]
Getting 2,700 for four years
is actually worth right now
[462]
$9,574, which is less than our option one.
[468]
This means option two is
not a good opportunity.
[472]
Now the good news is,
if you're using Excel,
[475]
we have a great function called the NPV,
[477]
it's the net present value,
[479]
and we can use that to quickly calculate
[483]
if an opportunity makes sense or not.
[486]
The first argument here is the rate,
[488]
which is this one.
[489]
And then we just need
to give it our value.
[492]
So this is the cash flow
returns that we're going to get,
[496]
which is this range right here.
[498]
If I press enter,
[499]
we get the same number that we got here,
[502]
we just got it in one step.
[504]
And to see if this opportunity
makes sense or not,
[507]
I can deduct it from my original option,
[512]
and I end up with minus 426,
[515]
which means it's not a good opportunity,
[517]
it's better for me to
get 10,000 right now,
[521]
instead of getting 10,800 over four years.
[525]
But all of this was
based on the assumption
[527]
that the discount rate is 5%.
[530]
What if the discount
rate was something else?
[532]
So what if it was 2%?
[534]
Then things start to change.
[535]
My net present value here is positive.
[539]
I end up getting more money,
[541]
with the discounted version of
option two, than option one.
[545]
So if the discount rate
was going to be that low,
[548]
and I could rely on this assumption,
[551]
I could say yes, 10,800 over four years,
[554]
is actually a better deal for me.
[557]
Now, you might be wondering,
[558]
what's the correct discount rate to use?
[561]
Well, that depends on how
you assess the three factors
[564]
impacting the time value of money.
[566]
Opportunity, cost, inflation,
[568]
and risk for your particular situation.
[571]
So for companies it's related
to how they get their funds.
[575]
They use a discount rate,
[576]
that's usually an
average of rate of return
[579]
that their investors expect,
[581]
and the cost of borrowing money.
[584]
That's called their back
[586]
for weighted average cost of capital.
[588]
By applying this as the discount rate,
[591]
any project that delivers a
positive NPV is worth doing.
[595]
So here's an example.
[597]
You want to buy a new
machinery that costs $50,000,
[601]
you calculated that it would bring
[603]
productivity savings of $15,000,
for the next four years.
[609]
Afterwards, the machine is
going to have to be replaced.
[612]
So if we don't consider the
return percentage right now,
[616]
and we just take a look at the cash flow,
[620]
we're going to have in
year one, the 15,000.
[623]
So let's just fix this with F4,
[625]
and the same amount
until end of year four.
[629]
In year zero, our cash flow is negative,
[632]
because we just spent $50,000 on this.
[636]
Now, if I just calculate
the sum of this on the side,
[640]
we're going to end up
with a profit of $10,000.
[644]
With this, we might think,
[646]
oh, that's actually not a bad investment.
[649]
And you go to your boss,
[650]
and you present this
business case to them.
[653]
Your boss takes a look at this and says,
[655]
"Okay, that's great,
[656]
"but the shareholders expect
[658]
"at least 8% return on their money."
[662]
So he only wants to invest in projects
[664]
that will give him at
least this kind of return.
[668]
Is the project worth doing now or not?
[671]
So let's see.
[672]
So let's put 8% right here,
[674]
and this time, let's
immediately take advantage
[677]
of Excel's NPV function.
[679]
Our rate is this one,
[682]
the values here are right here.
[685]
If I close bracket and I press enter,
[688]
this is the present value
of my future cash flows.
[692]
Now let's deduct the original
amount that I invested,
[695]
and since it's a minus here,
[698]
I'm just going to add
this to the NPV function,
[702]
and my net present value
ends up being negative.
[705]
This means that the project
[707]
is not going to deliver
the minimum return,
[710]
the shareholders are requesting.
[712]
But what if the minimum
return was a little less?
[715]
What if it was 6%?
[717]
Then everything starts to look different.
[719]
The net present value becomes positive.
[723]
So that's how this time
value of money is applied
[725]
in a simple business case.
[727]
I want you to take away two key things.
[731]
Always consider the timing
of when payments are done.
[734]
The further in the
future the payments are,
[737]
the lower their present value will be.
[740]
Think of the discount
rate as like a hurdle.
[744]
The higher the hurdle,
[746]
the more difficult it's going to be
[747]
to get a high present value.
[749]
If you're looking for a good
resource on personal finance,
[753]
or managing your money habits,
[755]
I can recommend Justin Bridges' course.
[758]
It's called Modern Money Habits:
[760]
five steps to build the life you want.
[762]
It's about taking charge
of your personal finances.
[765]
Now what I especially liked about it,
[767]
is how he records
everything in a spreadsheet.
[770]
So you have a clear
overview of your finances.
[774]
Taking classes in Skillshare
is really affordable too.
[777]
An annual subscription
is less than $10 a month,
[780]
and premium membership
gives you unlimited access,
[784]
so you can join any class and any topic
[786]
that interests you right now.
[788]
Whether that's freelancing,
[789]
technical skills, like office skills,
[791]
or any topic you'd like
to explore more of.
[794]
Because Skillshare is
sponsoring this video,
[797]
I have a special link for you
[798]
in the description of the video,
[800]
that is going to give you
two months free trial.
[803]
So make sure you check it out.
[805]
I hope this video was helpful for you
[806]
to get familiar with the concept
of the time value of money.
[812]
And I hope you enjoyed it,
[813]
if you did, give it a thumbs up,
[815]
and consider subscribing if
you haven't done so already.
[818]
(upbeat music)
Most Recent Videos:
You can go back to the homepage right here: Homepage