Net Present Value: Definition and Examples

Subject: Finance
Pages: 2
Words: 383
Reading time:
2 min

The cash flow profile of business investment decisions typically involves the outlay of a substantial cash sum now (time zero) followed by a series of cash inflows occurring over some defined future period. The problem is that the initial outlay is being spent now in the present time, whereas the future cash inflows which the investment is expected to generate will occur at different time periods over the future.

Cash flow amounts to be received at some future time are of less value than the same amounts received today, and the further into the future these cash flow amounts are expected to be received, the less their value. Therefore, an investment’s expected future cash inflows must be converted or discounted back to their present values so that they can be fairly compared with the present value of the initial investment outlay. To convert them to their present value, all the investment’s expected future cash inflows will be discounted at the investor’s opportunity cost of capital which is the rate of return the investor would expect to earn on investment of similar risk.

The net present value (NPV) is the difference between the present value of future cash inflows and the present value of the initial outlay, discounted at the firm’s cost of capital. Clearly, for a project to be viable, the present value of the cash inflows should be at least equal, or preferably exceed, the present value of the cash outflows. In applying the NPV technique, the decision rule is: “If the NPV is equal to or greater than zero, the project is considered acceptable; if the NPV is negative, the project should be rejected. NPV≥0 Accept; NPV <0 Reject

The net present value (NPV) is calculated using the formula:

Net present value NPV.

where NPV – net present value; IO – initial investment; CF – cash flow; t- any year; r – discount rate, n- project’s expected life. A zero NPV project earns just sufficient returns to compensate investors: a negative NPV project does not earn an adequate return. Clearly, the higher the positive NPV, the more value is added to the firm and the better off the firm will become.