Net Present Value Definition

Net Present Value (NPV), defined as the present value of the future net cash flows from an investment project, is one of the main ways to evaluate an investment. Net present value is one of the most used techniques and is a common term in the mind of any experienced business person.

Net Present Value Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. The NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects. When choosing between competiting investments using the net present value calculation you should select the one with the highest present value. If: NPV > 0, accept the investment. NPV < 0, reject the investment. NPV = 0, the investment is marginal

Net Present Value Discount Rate

The most critical decision variable in applying the net present value method is the selection of an appropriate discount rate. Typically you should use either the weighted average cost of capital for the company or the rate of return on alternative investments. As a rule the higher the discount rate the lower the net present value with everything else being equal. In addition, you should apply a risk element in establishing the discount rate. Riskier investments should have a higher discount rate than a safe investment. Longer investments should use a higher discount rate than short time projects. Similar to the rates on the yield curve for treasury bills. Other net present value discount rate factors include: Should you use before tax or after tax discount rates? AS a general rule if you are using before tax net cash flows then use before tax discount rates. After tax net cash flow should use after tax discount rate. Net Present Value Formula
The Net Present Value Formula for a single investment is: NPV = PV less I

Where: PV = Present Value I = Investment NPV = Net Present Value

The Net Present Value Formula for multiple investments is: The sum of all terms of: CF (Cashflow)/ (1 + r)t Where: CF = A one-time cashflow r = the Discount Rate t = the time of the cashflow

Net Present Value Calculation

For a single investment: $120,000 - $5,000 = $115,000 Where: PV = $120,000 I = $5,000 NPV = $115,000

For multiple investments: $120,000 / (1 + 10%)1 = $109,091 Where: CF = $120,000 r = 10% t = Year 1 NPV = $109,091shflow

Net Present Value Advantages

Net present value benefits include: - uses cash flow not earnings - eliminates time component - results in investment decisions that add value

Net Present Value Limitations

Net present value disadvantages include: - difficult to predict cash flows - assumes a constant discount rate over life of investmenNet Present Value Advantages Tells whether the investment will increase the firm's value Considers all the cash flows Considers the time value of money Considers the risk of future cash flows (through the cost of capital) Disadvantages Requires an estimate of the cost of capital in order to calculate the net present value Expressed in terms of dollars, not as a percentage

Present Value
Definition of 'Present Value - PV'
The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligation.

The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. Starting with the future value equation: FV = PV ( 1 + i ) t where FV = future value PV = present value i = annual interest rate

we see that the present value is given by: FV PV = (1+i)t The term 1 / ( 1 + i ) t is known as the discount factor. If both the future value and present value are known, one can solve for the time or the interest rate using one of the techniques discussed in future value calculations.
Present Value of Multiple Future Cash Payments

When there is more than a single cash payment at a future date, the present value is calculated by taking the present values of the individual cash payments and summing them. It is helpful to draw a time line depicting the timing of the cash payments:
Time Line

PV

C1

C2

C3

In this model, the cash payment at each date may be either an inflow or an outflow; the direction is designated by the sign. The present value of the above cash flow is: PV = C1 / ( 1 + i ) + C2 / ( 1 + i )2 + C3 / ( 1 + i )

Related Definitions
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Future Value - FV The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. There are two ways to calculate FV: 1) For an asset with simple ...

Internal Rate Of Return - IRR The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's ...

Net Present Value - NPV

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or .