What is NPV and payback and how do you calculate them?
Payback is the simpler of the two. It is when you get you initial investment back. For example, you spent $1M for a dairy farm that produces $250k of profit per year. Your payback period in this case would be 4 years. An NPV calculation discounts future cash flows in order make them equal to the value of today’s dollars. This is a more accurate, but complex method of evaluating an investment. Each successive cash flow is discounted more and more to reflect the risk and required return estimated in the discount rate used in the calculation. In our above example, if we used a discount rate of 10% we would get. NPV = -$1,000 + $250k/(1+10%)^1 + $250k/(1+10%)^2 + $250k/(1+10%)^3 + $250k/(1+10%)^4 NPV = -$1,000k + $227k + $207k + $188k + $171k NPV = -$208k The fact that the answer is negative shows us that our dairy farm is not a good investment over 4 years. We need to look longer term. After 6 years the investment turns positive (NPV = $89k). With this data you can say that a $1M investme
