Let’s consider a project that incorporates uncertainty. You believe that you have a compelling idea; an app for an on-demand dog-walking service called UnLeash.
You’ve run some numbers, and you think that you need $100,000 to build the company. You’re excited about UnLeash, but there are a lot of unknowns in the dog-walking market. You believe that in two years your venture has a 20% chance of being worth $1 million. But, you know a lot can go wrong. There is an 80% probability that the idea doesn’t pan out and UnLeash ends up worth $0.
Calculating Net Present Value
In Module 1, we introduced the concept of discount rates – the idea that value in the future is not worth as much as value today. We’re going to ignore those right now for simplicity, and assume that the discount rate is zero. Ignoring discount rates means we can just multiply the probabilities and payoffs to determine the expected value of the investment:
($1,000,000 * 20%) + ($0 * 80%) = $200,000
This is the present value of the uncertain future cash flow.
$200,000 − $100,000 = $100,000
This is the net present value of the uncertain future cash flow (in other words, the positive future cash flow value, minus the cost to build the company).
As you can see, the project has a net present value of $100,000 – the expected payoff is $200,000, which is only twice the $100,000 investment required to start it. Your idea is profitable though not terribly exciting given the high risk.