Net Present Value, or NPV, is a financial metric typically used to evaluate if an investment opportunity is worth pursuing based on its profitability. NPV is the difference between the present value of cash outflows and the present value of future cash inflows from the investment.
NPV is calculated by subtracting the present value of cash outflows from the total present value of future cash inflows. The present value of cash outflows is the capital that is invested. The present value of future cash inflows is calculated by dividing the future cash inflows by the denominator, (1 + i)t where i is the discount rate and t refers to the number of time periods to be discounted.
Calculation of net present value (NPV)
For example, an investor may invest $1,000 into an investment that spans over four years and is projected to receive payouts of $400 at the end of each year, with an annual interest rate of 5%. The present value of the cash outflow is $1,000. The discount rate is the annual interest rate of 5%. The total present value of future cash inflows is $1,418.38, calculated by discounting future cash inflows as shown below.
The NPV of the investment is $418.38, derived by subtracting the present value of cash outflow, $1,000, from the present value of future cash inflows, $1,418.38.
NPV takes into account the time value of money. Time value of money is a concept whereby current cash on hand is deemed to be more valuable as it can be used to generate more future cash inflows whereas the same amount of money in the future has a lesser value due to inflation that erodes the value of money over time. NPV takes this into account by discounting future cash inflows into the value of today’s dollars.
Secondly, NPV makes it easy for individuals and firms to evaluate if an investment is worth pursuing since both initial capital and the returns are presented in today’s dollars.
Is a higher net present value (NPV) better?
Generally, a higher NPV is preferred. A positive and higher NPV suggests that the investment would be more profitable, with returns exceeding the initial capital. A negative NPV typically suggests that the investment may result in a net loss.
Limitations of net present value (NPV)
When using NPV, assumptions and estimates are made for the investment costs, discount rates and projected returns. Therefore, the calculated NPV may not be the actual NPV.
For example, when discounting future cash inflows to its present value, the discount rate used is constant throughout the time periods. However, in reality, interest rates may fluctuate throughout the years. When interest rates increase, the future cash inflow would decrease in value, therefore decreasing the actual NPV. Whilst a positive NPV typically suggests that the investment would be profitable, investors should be aware of the assumptions and estimates made and should not make investment decisions solely based on NPV.
Net present value (NPV) versus internal rate of return (IRR)
Both NPV and internal rate of return, or IRR, are capital budgeting methods and are typically used to evaluate if an investment is worth pursuing based on its profitability. Although calculating IRR uses the same formula as NPV, IRR results in a percentage return whereas NPV gives a dollar figure for the total return, taking into account the time value of money.
Secondly, IRR is a discount rate that focuses on the breakeven cash flow by assuming the NPV of an investment is equal to zero whilst NPV focuses on the net profit of an investment.
Calculation of internal rate of return (IRR)
IRR is calculated by assuming NPV is equal to 0. This is usually done on a spreadsheet tool or with the use of a financial calculator.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.