DEFINITION of '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 project.
The following is the formula for calculating NPV:
Ct = net cash inflow during the period
Co= initial investment
r = discount rate, and
t = number of time periods
In addition to the formula, net present value can often be calculated using tables, as well as spreadsheets such as Microsoft Excel.
INVESTOPEDIA EXPLAINS 'Net Present Value - NPV'
Determining the value of a project is challenging because there are different ways to measure the value of future cash flows. Because of the time value of money, a dollar earned in the future won’t be worth as much as one earned today. The discount rate in the NPV formula is a way to account for this. Companies have different ways of identifying the discount rate, although a common method is using the expected return of other investment choices with a similar level of risk.
For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount of, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.
Interested in more information on Net Present Value (NPV)? Check out Time Value of Money: Determining Your Future Worth and our Introduction To Corporate Valuation Methods.