What is Net Present Value (NPV)?
Net Present Value (NPV) measures the profitability of an investment by calculating today's value of all future cash flows, discounted at a required rate of return. A positive NPV means the investment adds value to the company.
NPV = Σ(Cash Flow_t ÷ (1 + Discount Rate)^t) − Initial Investment. If NPV > 0, the investment is profitable. NPV allows comparison of projects with different timings and sizes.
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Step-by-step worked examples
A company invests $50,000 in equipment generating $15,000/year for 4 years. Discount rate = 8%. Calculate NPV.
PV Year 1: $15,000 ÷ 1.08 = $13,889 PV Year 2: $15,000 ÷ 1.08² = $12,860 PV Year 3: $15,000 ÷ 1.08³ = $11,907 PV Year 4: $15,000 ÷ 1.08⁴ = $11,029 Total PV = $49,685 NPV = $49,685 − $50,000 = −$315 (slightly negative, borderline reject)
Project A: $80,000 investment, $25,000/year for 5 years, 10% discount rate. Calculate NPV.
PV = $25,000 × [1 − (1.10)^−5] ÷ 0.10 = $25,000 × 3.791 = $94,775 NPV = $94,775 − $80,000 = $14,775 (accept: positive NPV adds value)
Project B: $200,000 investment, $60,000/year for 5 years, 12% discount rate. Calculate NPV.
PV Year 1–5 annuity: $60,000 × 3.605 (5-year, 12% annuity factor) = $216,300 NPV = $216,300 − $200,000 = $16,300 (accept: strong positive NPV)
Flashcards
Quick quiz
Q1.An investment has positive NPV. This means…
Q2.What does a discount rate of 10% mean?
Q3.If NPV = −$5,000, should you invest?
Q4.Higher discount rate → NPV becomes…
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Common mistakes
NPV only considers time value of money, not risk. — Correct: Discount rate embeds risk — riskier projects use higher rates, reducing NPV.
A project with positive NPV always succeeds. — Correct: Positive NPV assumes correct forecasts; real-world execution risk may differ.
The discount rate is always the inflation rate. — Correct: Discount rate = risk-free rate + risk premium. It varies by project risk and company cost of capital.
NPV ignores the size of the investment. — Correct: NPV is dollar-based but investors also compare profitability index (NPV ÷ investment) across projects.
FAQ
What is NPV and why is it important?
NPV is the present value of an investment's future cash flows minus its cost. It's the best tool for comparing projects of different sizes and timings.
What's the difference between NPV and payback period?
Payback period = when you recover your investment. NPV = total value created. NPV is better because it accounts for all cash flows and time value of money.
How do you choose the discount rate?
Use the company's cost of capital (weighted average of debt and equity costs) plus a risk premium for the specific project.
Can NPV be used for non-financial decisions?
Yes — NPV principles apply to any decision with costs and benefits over time (e.g., technology upgrades, process improvements).