What it means
Net present value, usually shortened to NPV, answers a simple question: is this investment worth more than it costs, once timing is taken into account? A dollar received in three years is worth less than a dollar today because you could have invested the dollar in the meantime and because the future is uncertain.
NPV puts every cash flow on the same footing by translating it into today's money. To do this, each future cash flow is divided by one plus the discount rate, raised to the number of years.
The discount rate is the minimum return the business wants, often based on its cost of capital or the risk of the project. The discounted flows are added up, and the up-front cost is subtracted to give the net figure.
The decision rule is easy to apply. If the NPV is positive, the project is expected to create value above the required return, and if it is negative, it is expected to destroy value.
When choosing between projects with limited funds, managers often compare NPVs, because it measures the dollar value added, not just a percentage. NPV is only as good as the inputs.
The forecast cash flows and the discount rate are both estimates, and a small change in either can flip the answer. Good practice is to test a range of scenarios and see how sensitive the result is.
A common variant is to compare NPV with the internal rate of return (the discount rate that makes NPV exactly zero). The two usually agree on whether to accept a project, but they can disagree when ranking projects of different sizes or timings, and NPV is generally the safer guide.
In practice
Real-world examples
Example 1
A logistics firm considers buying a $250,000 sorting machine that saves $80,000 a year for five years. Finance discounts the savings at the company's required return and finds a positive NPV. The purchase goes ahead.
Example 2
A marketing director proposes a $60,000 campaign expected to bring in extra gross profit over two years. The NPV comes out slightly negative at the required return, so the campaign is redesigned with a smaller budget. The revised plan clears the hurdle.
Example 3
A private equity analyst values a small bakery chain by discounting ten years of forecast cash flows plus a final sale value. The resulting NPV is the most she should pay for the business if she wants to earn her target return. She bids below it to leave a margin of safety.
Think of it
NPV is like calculating whether a coupon book is worth buying. You estimate savings, adjust for when you'll use them, and compare to the purchase price.
Formula
Calculation
NPV = (cash flow in year 1 / (1 + r)) + (cash flow in year 2 / (1 + r)^2) + ... - initial investment, where r is the discount rate
Suppose a business invests $100,000 and expects cash inflows of $40,000, $50,000 and $60,000 over the next three years, using a discount rate of 10%. Year 1: 40,000 / 1.10 = $36,364. Year 2: 50,000 / 1.21 = $41,322. Year 3: 60,000 / 1.331 = $45,079. The present value of the inflows is 36,364 + 41,322 + 45,079 = $122,765, so NPV = 122,765 - 100,000 = $22,765, and the project is worth doing.Case study
Seen in the real world
Brightwater Foods is a fictional food producer invented for this illustration. Its managers were choosing between two projects: a new packaging line costing $500,000 and a new product range costing $300,000, with only $500,000 available.
The packaging line had a larger total cash return, but most of it arrived late. When the finance team discounted both at 12%, the packaging line showed an NPV of $40,000, while the new product range showed $90,000 because its cash came sooner.
The illustrative result was that the smaller project created more value per dollar of funding, and the team chose it and also had $200,000 left for a smaller upgrade. The discussion also forced the managers to challenge the sales forecast for the product range before approving it.
Watch out
Common mistakes
- Using the wrong discount rate, such as a bank loan rate, when the rate should reflect the risk of the project and the return investors require.
- Forgetting that cash flows should include working capital and tax effects, not just sales and direct costs.
- Treating a positive NPV as a guarantee, when it is only as reliable as the forecasts behind it.
Questions
People also ask
Can NPV be negative and still be worth pursuing?
Sometimes, if the project brings strategic benefits that are not captured in the forecast cash flows, but the reasons should be stated and valued explicitly.
What discount rate should I use?
Most companies use their weighted average cost of capital, adjusted up or down for how risky the project is compared with the business as a whole.
Why not just add up the cash flows?
Because a dollar next year is worth less than a dollar now, and ignoring that makes distant, uncertain cash look as valuable as immediate cash.