What Is Net Present Value And Why IT Managers Should Care About It?

by drjim on November 15, 2012

You're going to have to get your calculator out to figure out Net Present Values…

You’re going to have to get your calculator out to figure out Net Present Values…
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The good news is that IT managers are often able to quickly wrap their heads around the concept that a dollar (or a euro, or a rand, or a…) in an IT budget that they are given today is more valuable than a dollar that they are given tomorrow. However, things get a bit more trickery when we try to determine the net present value of money that we might get tomorrow…

What Is Net Present Value?

So you may have heard the term “NPV” before, but just exactly what is it? The leadership of your company probably uses this term quite frequently, so you need to know all about it. In this case, perhaps an example would help you to understand it. Let’s say that I come up to you and tell you that I’m going to give you US$1,000,000 five years from now. Hopefully, you’d be thrilled to hear that.

However, after awhile you might start to think to yourself – hey, I really don’t want to wait 5 years to get my hands on that money. I’d like to have it right now. Assuming that I was agreeable to giving you the money, I would not be willing to give you the full $1,000,000 – after all, that’s how much I said that I’d give to you in 5 years, not today. In fact, I might not even have the $1,000,000 to give it to you today.

So how much would I be willing to give to you? Well, there are a lot of very good Net Present Value calculators on the Internet and they are easy to find. Assuming that you found one and that you also did some research and discovered that if you put money in the bank today and let it sit there, it would grow by 10% every year, then what you’d discover is that I should be willing to give you $620,000 today. The NPV calculations show that $620,000 over 5 years at a 10% interest rate will give you $1,000,000 in 5 years.

In a nutshell, that’s what NPV is. It’s simply the present value of a future sum. What you do to calculate the present value of a future payment is to discount the future payment at some annual compound interest rate.

How Can IT Managers Use Net Present Value?

So knowing what NPV is can be a powerful tool for any IT manager. However, the next question is why do I need to know about this? Ultimately what all of this comes down to is that NPV is a decision making tool that you can use when you are trying to make decisions about what your IT dream team should be working on.

One note, we refer to it as “net present value” (and not “present value”) because when we are using it, after we calculate the present value we’ll go ahead and subtract off any initial investment costs.

The question that you’ll want to be asking yourself when you are using NPV is if the initial investment that you’d have to make in an IT project would be worth the future benefit that the project will deliver.

Using the numbers that we calculated above, if the initial startup costs for an IT project were $650,000 and the project would result in savings to the company of $1,000,000 in 5 years, then the answer would be no – the investment in doing the project would not be worth it.

What Does All Of This Mean For You?

Net Present Value (or NPV) is a financial tool that IT managers can use during budgeting and project planning processes to help with their discussions with company management. NPV tells an IT manager what the current value of money that they’ll receive in the future is.

The value of knowing this amount is that it can help in the decision making process. When planning an IT project, the use of NPV can help an IT manager make the decision as to if spending IT budget dollars on this project is the best use of limited IT funds.

NPV is a simple financial concept that the rest of the company uses every day. IT managers need to understand what NPV is and how to use it in order to be able to successfully communicate their funding needs and plans with the rest of the company.

– Dr. Jim Anderson
Blue Elephant Consulting –
Your Source For Real World IT Management Skills™

Question For You: Where do you think you should get the interest rate values that you use when calculating your project’s NPV?

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What We’ll Be Talking About Next Time

As an IT manager you will eventually be responsible for convincing your company to fund an IT project that your IT dream team wants to work on. Sure, from a technology point-of-view this may be a necessary project to do; however, the leadership in your company who control the funding probably don’t really care about that – they want to know how much money the company is going to make if you do this project.

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