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Measurement of NPV (Net Present Value)
Suppose a plot of land is worth $1 million today but expected to be worth
$1.2 million in a year, would you buy it? Why or why not?
For average farmers, this situation involves a long term decision making process. We first need to know the level of interest rates. Suppose the interest rate is 9%, we can use the formula for present value to measure NPV:
PV0 = FV1 x 1/(1+i)
Where:
FV1 is future expected value of land at end of the year (year 1)
PV0 is discounted value or present equivalent of the expected
future value (year 0),
i is the interest rate
NPV is the net present value (present value of investment less initial cost)
PV0=1,200,000 x 1/(1+0.09) = 1,100,917
Therefore NPV = 1,100,917-1,000,000=100,917
Since 100,917 is positive, one can invest in this land.
NPV represents the contribution of that investment to the value of the firm which is the value to shareholders. The higher the NPV, the more attractive is the investment. Thus, shareholder wealth is maximized when NPV is positive or return on investment (ROI) is greater than required rate of return (RRoR).
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