A:

Present value (PV) is the current value of a future sum of money or stream of cash flow given a specified rate of return. Meanwhile, net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Difference Between PV and NPV

While both PV and NPV use discounted cash flows to estimate the current value of future income, these calculations differ in one important way. The NPV formula accounts for the initial capital outlay required to fund a project, making it a net figure, while the PV calculation only accounts for cash inflows. Though understanding the concept behind the PV calculation is important, the NPV formula is a much more comprehensive indicator of a given project's potential profitability.

Since the value of revenue earned today is higher than that of revenue earned down the road, businesses discount future income by the investment's expected rate of return. This rate, called the hurdle rate, is the minimum rate of return a project must generate for the business to consider investing in it.

Calculating PV and NPV

The PV calculation indicates the discounted value of all revenue generated by the project, while the NPV indicates how profitable the project will be after accounting for the initial investment required to fund it.

For example, assume a given project requires an initial capital investment of $15,000. The project is anticipated to generate revenues of $3,500, $9,400 and $15,100 in the next three years, respectively, and the company's hurdle rate is 7%.

The present value of the anticipated income is:

$3,500 / (1 + 0.07) ^ 1) + $9,400 / (1 + 0.07) ^ 2 + $15,100 / (1 + 0.07) ^ 3, or $23,807.

The NPV of this project can be determined by simply subtracting the initial capital investment from the discounted revenue:

$23,807 - $15,000 = $8,807.

While the PV value is useful, the NPV calculation is invaluable to capital budgeting. A project with a high PV figure may actually have a much less impressive NPV if a large amount of capital is required to fund it. As a business expands, it looks to finance only those projects or investments that yield the greatest returns, which in turn enables additional growth. Given a number of potential options, the project or investment with the highest NPV is generally pursued.

RELATED FAQS
  1. What are the disadvantages of using net present value as an investment criterion?

    While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no ... Read Answer >>
  2. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  3. How do you use a financial calculator to determine present value?

    Learn how to utilize a financial calculator to calculate present value. Understand the necessary data, why it is important ... Read Answer >>
  4. Why does time value of money (TVM) assume that a dollar today is worth more than ...

    Learn about time value of money, or TVM, and how a present value calculator is used to determine the value of money received ... Read Answer >>
  5. Why would you take DCF into account rather than simply projecting future revenues?

    Learn what discounted cash flow analysis is and why it is considered a better equity valuation tool than simply projecting ... Read Answer >>
Related Articles
  1. Investing

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  2. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  3. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  4. Investing

    Understanding the Time Value of Money

    Find out why time really is money by learning to calculate present and future value.
  5. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
RELATED TERMS
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  2. Adjusted Present Value - APV

    The Net Present Value (NPV) of a project if financed solely by ...
  3. Bullet Bond

    A debt instrument whose entire face value is paid at once on ...
  4. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  5. Discounting

    Discounting is the process of determining the present value of ...
  6. Accounting Rate of Return - ARR

    The amount of profit, or return, that an individual can expect ...
Hot Definitions
  1. Moving Average - MA

    A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out ...
  2. Stop Order

    A stop order is an order to buy or sell a security when its price increases past a particular point in order to limit losses ...
  3. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
  4. Candlestick

    A chart that displays the high, low, opening and closing prices for a security for a single day. The wide part of the candlestick ...
  5. Indicator

    Indicators are statistics used to measure current conditions as well as to forecast financial or economic trends.
  6. Liability

    Liabilities are defined as a company's legal debts or obligations that arise during the course of business operations.
Trading Center