Net Present Value (NPV)

What is Net Present Value (NPV)?

Net Present Value (NPV) is a financial tool used to assess whether an investment or project will be profitable by calculating the value of its future cash flows in today's terms. It helps determine if the expected returns will exceed the initial investment, helping you decide if a project is worth pursuing.

Key Concepts

Time Value of Money: NPV is based on the idea that money today is worth more than the same amount in the future because it can earn interest or be invested elsewhere.

Discount Rate: The discount rate represents the return you could expect from an alternative investment, factoring in the risk.

Steps to Calculate NPV

Estimate Future Cash Flows: Predict the expected cash inflows and outflows for each period.

Choose a Discount Rate: Select an appropriate rate based on the investment's risk.

Calculate Present Values: Discount future cash flow to its present value

Sum Present Values: Add up all present values of inflows and subtract the initial investment.

Interpreting NPV

Positive NPV: The project is expected to be profitable, as the earnings (in today's value) are greater than the costs.

Negative NPV: The costs outweigh the earnings, meaning the investment may result in a loss.

Zero NPV: The return will be exactly equal to the discount rate, with no profit or loss.