The Net Present Value (NPV) is a number calculated by investors to determine the profitability of a proposed project. NPV can be very useful for analyzing an investment in a business or a new project within a business.
NPV takes into account all projected cash inflows and outflows and uses a concept known as the time value of money to determine whether a particular investment is likely to generate gains or losses. NPV as a metric gives some unique advantages and also has some drawbacks that make it irrelevant for some investment decisions.
How Net Present Worth Works
To understand NPV, let’s first look at the time value of money, which is the idea that having a dollar in the future is not worth as much as having that dollar today. By discounting the future cash flows by how long they are expected to be in the future, and then adding each of these present values together, a number is obtained that represents the net present value of those projected cash flows. A positive number indicates that the project is profitable on a net basis, while a negative number indicates that the project would create a net loss.
Net Present Value (NPV) Formula
The initial investment required to launch the project is the first term in this equation, and it is negative because it represents an expenditure of money.
The second term represents the first cash flow, perhaps for the first year, and it can be negative if the project is not profitable in the first year of operation. The third term represents the cash flow for the second year, and so on, for the number of years projected.
A discount rate, r, is applied, with (1 + r) increased to the number of years in the future that a cash flow is projected. The exponent “T” in the denominator of this NPV equation is central to the concept of the time value of money, because high T values cause distant cash flows to discount exponentially.
This equation can be done in Excel, on a financial calculator, or, for the ambitious, calculated by hand.
How to calculate net present value
Using the data below, let’s walk through an example to better understand how to determine the NPV of a project.
Imagine that you have the opportunity to invest $ 15,000 to grow your business, then estimate that this investment will generate $ 3,000 in profit per year over the next 10 years. Your business’s cost of capital, which serves as the discount rate, is 10% per year.
The present value in the table above is the value of each projected cash flow discounted to its equivalent value today. The sum of the projected values and the subtraction of the initial down payment of $ 15,000 produces a net present value for the project of $ 3,433.70. Since the NPV number is positive, the project is likely to be profitable.
Advantages and disadvantages of NPV
|Benefits of NPV||Disadvantages of NPV|
Integrates the time value of money.
The precision depends on the quality of the inputs.
An easy way to determine if a project is delivering value.
Not useful for comparing projects of different sizes, as the largest projects usually generate the highest returns.
Consider the cost of capital for a business.
Can omit hidden costs such as opportunity costs and organization costs.
|Takes into account the uncertainty inherent in projections by most strongly updating estimates for the distant future.||Purely quantitative in nature and does not take into account qualitative factors.|
Frequently asked questions about NPV
Read on for answers to the most frequently asked questions about NPV.
What is the difference between NPV and IRR?
The internal rate of return (IRR) is the annual rate of return that a potential project is expected to generate. IRR is calculated by setting the NPV in the above equation to zero and solving the rate “r”.
While NPV and IRR can be useful in evaluating a potential project, the two measures are used differently. The NPV of a project only needs to be positive for the effort to be worth it, while the IRR that results from setting the NPV to zero is compared to the required rate of return of a company. Projects with an IRR greater than the required rate of return are generally viewed as attractive opportunities. IRR is also more useful than NPV for evaluating projects of different sizes.
What is a good NPV?
A positive NPV is a good NPV. A project with a positive NPV should be continued, while a project with a negative NPV should not. A project with a NPV of zero would confer neither financial benefit nor harm.
However, a “good” NPV is as good as the inputs into the NPV equation. Just guessing a project’s future cash flows and discount rate produces an unreliable NPV that is not very useful.
Why are future cash flows discounted at NPV?
Simply put, because of the time value of money. A dollar in the future is worth less than a dollar today, and incorporating this concept into financial models is the best way to make investment decisions now. The future is uncertain, and inflationary pressures further weaken the value of a dollar over time.