What Is Net Present Value (NPV)?
- Net Present Value (NPV) is a method used to evaluate whether an investment is worth pursuing.
- It calculates the present value of all future cash flows and subtracts the initial investment to determine if the project will be profitable.
Definition
Net Present Value
NPV is a financial metric used to evaluate the profitability of an investment or project. It calculates the difference between the present value of cash inflows and the present value of cash outflows over a given period.
Why Does NPV Matter?
- Considers the Time Value of Money: A dollar today is worth more than a dollar in the future.
- Helps Compare Investments: NPV shows which projects generate more value.
- Ensures Profitability: A positive NPV means the project adds value, while a negative NPV suggests a loss.
Definition
Time Value of Money
The Time Value of Money is the concept that a sum of money has greater value now than the same sum in the future due to its potential earning capacity.
- If you invest $100,000 today and expect to receive $120,000 in two years, is that a good investment?
- NPV helps determine whether the future cash inflow is worth it when adjusted for the time value of money.
- If you have $1,000 today and invest it at a 5% interest rate, it will grow to $1,050 in a year.
- Conversely, $1,050 received a year from now is worth only $1,000 today.
How to Calculate NPV
- To calculate NPV, follow these steps:
- Identify Cash Flows: Determine the initial investment and the expected future cash inflows.
- Choose a Discount Rate: This reflects the opportunity cost of capital or the expected rate of return.
- Calculate Present Value (PV): Use the formula: $$\text{PV} = \frac{\text{Future Cash Flow}}{(1 + r)^n}$$
- $r$ = discount rate
- $n$ = number of years into the future
- Compute NPV: Subtract the initial investment from the sum of the present values of future cash flows: $$\text{NPV} = \sum \text{PV of Future Cash Flows} - \text{Initial Investment}$$
