Net present value (NPV) is a capital budgeting method used to evaluate the profitability of projects over a specified period of time. This calculation uses a discounted cash flow model to estimate the financial return on investment of a project. This is based on the current market price of a dollar that is invested now versus the expected cash inflows generated by the potential project over a given period of time.
In other words, NPV helps determine the money that you need to invest today to get positive cash flows tomorrow.
The main objective of the NPV method is to calculate the present value of future cash flows. This calculation helps financial leaders make better business decisions about investment opportunities. The NPV helps determine how much capital a business leader should invest, or whether or not an investment decision now makes sense based on the expected rate of return and costs of investment.
How to calculate the current value of future cash flows
If you have a series of cash flows that are expected to occur in the future, how do you calculate the present value of those incoming and outgoing cash flows?
The answer is simple: You multiply each expected cash flow by its respective discount rate. The discount rate factor is simply the interest rate at which you would borrow money today to invest in the asset or business that will generate future cash flow.
The formula for calculating the net present value (NPV) of investment requires three inputs:
A cash flow stream: this is the amount of money you receive each period over a certain amount of time.
A discount rate: this is the interest rate that represents how much it costs you to borrow the funds needed to make the initial investment.
Time: the length of time required to complete the long-term project.
Formula
Where:
i = required return or discount rate
t = # of time periods
If the potential investment has a positive NPV it means it is worthwhile because the sum of the cash flow stream plus the interest payment (cost of capital) equals more than the initial investment.
NPV: Positive vs. negative
A positive NPV indicates that an investment will generate sufficient cash inflow to cover its expected initial cost. In other words, it is a good deal.
A negative NPV, however, means that the current cost of investment exceeds the incoming cash flows that are expected to be generated by the project. This means that you shouldn’t invest too much money into something that isn’t will not be able to generate enough returns to pay off your debt.
