What it means
The idea behind NPV is that a dollar today is worth more than a dollar in the future, because today's dollar can be invested and because the future is uncertain. To compare cash flows that arrive at different times, NPV converts each one into today's money using a discount rate.
The discount rate usually reflects the company's cost of capital or the return available on similarly risky alternatives. To calculate NPV, you list the expected cash flows for each period, discount each one back to the present and add them up, including the initial investment as a negative number.
If the total is above zero, the project earns more than the required return, and if it is below zero it falls short. Many managers use it as the main test for capital budgeting decisions.
NPV has strengths. It uses cash rather than accounting profit, it considers timing, and it shows the result in dollars rather than as a percentage, so projects of different sizes can be compared by the value they add.
It also adds together neatly, so the NPV of two independent projects is the sum of the two. It also has weaknesses.
The answer depends heavily on the forecast cash flows and the chosen discount rate, and small changes in either can flip the result, so analysts often run a sensitivity analysis. NPV is also less intuitive for non-finance staff than a payback period or a simple percentage return.
In practice, NPV is used for decisions such as buying equipment, opening a store, launching a product or acquiring a business. It is often paired with the internal rate of return, but when the two disagree, NPV is generally considered the more reliable guide for mutually exclusive projects.
In practice
Real-world examples.
Example
A bakery is considering a $60,000 oven that will save $15,000 a year in costs for six years. The owner discounts the savings at 8% and finds that the present value of the savings is more than $60,000, so the NPV is positive and she buys the oven.
Example
A software company evaluates building a new product with development costs of $400,000 and uncertain sales. Using a 12% discount rate and a range of forecasts, the analysts find that the NPV is negative in the base case, so the board delays the project.
Example
A retail chain compares two store locations that each cost $1,500,000 to open. Location A has an NPV of $220,000 and location B has an NPV of $90,000, so management chooses location A.
Formula
Calculation
NPV = Sum of [Cash flow in year t / (1 + r)^t] - Initial investment
Suppose a company invests $100,000 in a machine that is expected to generate cash flows of $50,000 in year 1, $60,000 in year 2 and $30,000 in year 3, with a discount rate (r) of 10%. Year 1: $50,000 / 1.10 = $45,455. Year 2: $60,000 / 1.21 = $49,587. Year 3: $30,000 / 1.331 = $22,539. The present value of the inflows is $45,455 + $49,587 + $22,539 = $117,581, so NPV = $117,581 - $100,000 = $17,581, which is positive and suggests the investment should be accepted.Case study
Seen in the real world.
Stonebridge Dairy is a fictional company deciding whether to spend $2,000,000 on a new packaging line. The operations team projected savings that looked large when added up over ten years, and the plant manager argued that the machine would pay for itself comfortably. The finance manager asked for a discounted calculation.
At a 9% discount rate, the discounted savings came to less than the cost of the line, giving a negative NPV of about $150,000. In this illustrative case the company negotiated a lower price from the supplier and extended the maintenance contract, which brought the NPV above zero. The decision was approved only after the numbers supported it.
Watch out
Common mistakes.
- Adding up future cash flows without discounting them. This overstates value because it ignores the time value of money.
- Using accounting profit instead of cash flow. NPV needs actual cash movements, including capital spending and changes in working capital.
- Choosing an arbitrary discount rate. The rate should reflect the risk of the project, and a poor choice can make a bad project look good.
Questions
People also ask.
What is a good NPV?
Any NPV above zero means the project earns more than the required return, and between options the higher NPV adds more value.
What is the difference between NPV and IRR?
NPV gives the value created in dollars at a chosen discount rate, while IRR gives the rate at which NPV equals zero.
Can NPV be negative and still worth doing?
Occasionally, for strategic or regulatory reasons, but the negative NPV is then the price paid for those benefits and should be a conscious choice.
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