Monday, January 31, 2011

Net Present Value (NPV) and Discounted Cash Flow


To be a negotiator there are times when you need to understand certain financial concepts and Net Present Value and Discounted Cash Flow is one of those concepts negotiators should know.

Net Present Value looks at what a future cost is worth in today’s dollars. Discounted Cash Flow looks at how much of an investment would need to be made today to make a payment or investment in the future. Net Present Value takes into account the fact that the other party will have the benefit of using the money in the interim and getting the compounding effect on that, making it worth less to you (as you aren’t getting the compounding effect of the money). Discounted Cash Flow takes into account the fact that you will have the benefit of the investment and would be earning a return and get the benefit of compounding in the interim so the amount you need to invest today to make a payment in the future is less than the payment amount.

The NPV is calculated by dividing 1 by (1 plus the interest rate) N  where n equals the number of years. For example if you had a value of money of 12%, and the agreement was to pay you $1.00 three years from now, the NPV calculation would be:
                 1                         1                            1                         1
NPV  --------------  or   ----------------   or    ------------------      or    -----------   =  $.7117                     
            (1 + rate)n         (1 + .12)3             1.12 x 1.12 x 1.12       1.4049

This means that a commitment to pay you $1.00 three years in the future is equivalent to you having $.71 today. From a discounted cash flow perspective it would mean that for you to have that $1.00 three years in the future, you would need to invest $.71 today.

Net Present Value or Discounted Cash Flow deal with the concept of time value of money. That’s important to Procurement as throughout a contract there are promises to make payments, hold inventories, and pay damages, all which may have a time value impact. For example, if you were purchasing a major piece of equipment there can be a significant difference in the NPV based upon the payment schedule. Sometimes the issue of time value of money exists in the subtleties of the language used or the changes Suppliers try to negotiate. For example compare the same commitment, but with one word inserted:
            “Supplier will pay all damages awarded.” 
                                     versus 

What’s the difference?  The difference is when you will get paid. In the first, once damages are awarded the Supplier must pay. In the second, payment will occur at some point in the distant future after the Supplier no longer has any possible appeals so the award is final. You will still get paid a dollar, but on a net present value basis you will get less.  Using a 12% value of money, here’s what they would be worth depending on timing:

Time to get paid
Current value of that payment commitment
1 year
$.89
2 years
$.79
3 years
$.71
4 years
$.63
5 years
$.56
6 years
$.50
8 years
$.40
10 years
$.38

So in the change of the language example, changing it from damages awarded to damages finally awarded would mean that the Supplier would not have to pay you until the award is final, meaning that they exhausted all means of appeal. If that took 8 years to happen, from a Net Present Value perspective it would mean that commitment to pay is really paying you the equivalent of 40% of what it would be worth if they paid you today. Sure if the award was $100,000 you would still be paid $100,000. The difference in value is because they are holding the money not you, so they would be getting the compounding effect of the investment on that money. 

Another way to look at it is from a discounted cash flow perspective, all they would need to invest today to pay you the $100,000 in 8 years if they had a 12% return on their money is $40,000.

Another way to look at it is if they paid you the $100,000 today and you were able to get a 12% simple return on your money here’s what it would be worth to you during the same period.
Term
Worth
Day 1
100,000
End of 1st year
112,000
End of 2nd year
125,440
End of 3rd year
140,492
End of 4th year
157,351
End of 5th year
176,234
End of 6th year
197,382
End of 7th year
221,068
End of 8th year
247,596

So that one additional word in the commitment could cost you $147,598. That’s the  difference between being paid $100,000 at the end of the eighth year by the Supplier when the award was final versus having $247,596 because you were paid immediately and had the compounding effect on your money.

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