## What Is Net Present Value (NPV)?

Net present value (NPV) is the** projected return on an investment **adjusted to reflect the** present value of money**. It estimates the total amount of money a project will generate in its lifetime in today’s dollars.

Using a **net present value calculator**, you can easily quantify the present value of expected cash inflows and outflows, helping you to make informed investment decisions.

If you’re already familiar with all the formulas and terminology, you can skip this section scroll to our calculator.

NPV is a **profitability metric** that answers the question:* Will the income generated by this project exceed the upfront investment?*

**Pro Tip:** Regularly performing sensitivity analyses on your NPV calculations can help you understand how changes in input variables like discount rates or cash flow estimates could impact your investment’s profitability.

**Key Takeaways: The Basics of Net Present Value (NPV)**

- NPV helps determine the profitability of investments by taking into account the time value of money.
- A positive NPV indicates an investment is expected to generate profit over its costs, while a negative NPV suggests the opposite.
- NPV calculations include the initial cash outlay, projected cash flows, and a discount rate that reflects the minimum acceptable return.
- NPV reflects that money available now is worth more than the same amount in the future due to its potential earning capacity.
- Businesses use NPV to choose between multiple investment opportunities, ensuring they select the most profitable or least costly option.

**Pro Tip:** Use NPV to negotiate better terms with investors by showing the precise value an investment will bring over time.

## How Does Cash Change Value Over Time?

Net present value relies on a concept called the **time value of money**. This is the idea that **a dollar today is worth more than a dollar in the future**. Two factors impact the future value of cash.

**Inflation.**If inflation is 3%, $1k cash will have the purchasing power of $970.87 a year from now. Another way to say this is that $1k a year from now has a present value of $970.87.**Potential gains from investing**. Any cash you have available now could be invested and earn dividends or increase in value. Based on the S&P 500 over the last century, the average stock market return is 10% per year, so, in theory, $1k cash has the potential to become $1,100 a year from now. In other words, unspent cash has an opportunity cost.

## Understanding Net Present Value in Your Business

To convert a sum of money into today’s dollars, you can use the** present value formula**, where r is the rate of return and n is the number of periods.

Imagine your boss tells you that you will receive a loyalty bonus of $1k if you stay with the company for 5 years. Let’s use 10% as the rate of return that represents the opportunity cost.

*Present value = 1,000/(1+0.1)^5 = 621*

Therefore, the bonus is worth $621 in today’s money.

Naturally, this won’t be spot on to the real value after 5 years but it should still be a helpful estimation to inform your financial decisions.

## When Is Net Present Value Used

It’s useful to calculate net present value **whenever cash is spent today to generate future returns**, including when:

- deciding whether to launch a new venture
- evaluating investment opportunities
- conducting a valuation on a business
- choosing between different projects
- managing a project to maximize returns
- making a big business purchase e.g. software or equipment
- contemplating a personal financial decision e.g. buying a home

**Remember:** Net present value allows you to assess and compare the potential profitability of these investments.

### Why Is Net Present Value Important?

Net present value is crucial as it allows investors and businesses to evaluate an investment’s profitability by considering the time value of money.

It helps in **understanding whether the returns from an investment will exceed its costs within a specific period**, aiding in strategic financial planning and risk assessment.

## How to Calculate Net Present Value (Step-by-Step)

Let’s take a look at the variables that make up the net present value calculation.

**1. Initial investment.** This could be the capital you need to launch a project, the cost of purchasing new equipment, or the amount you want to invest in a startup or investment portfolio.

**2. Net cash flow. **This is an estimate of the amount of money a project will generate over its lifetime or a chosen period, taking into account any expenses.

**For example:** Suppose you are analyzing the net present value of a new delivery vehicle. In year 1, the vehicle will generate an extra $50k in sales and cost $5k to operate, so your net cash flow is $45k. Similarly, if an investment portfolio generates annual returns of $1k and the monthly fees are $30, the net cash flow for the year is 1,000 – (30×12) = $640.

**3. Discount rate. **The term for adjusting a value so it is expressed in today’s money is ‘discounting’. The discount rate is the rate at which cash changes value over time. It is expressed as a decimal.

Depending on what you are analyzing, you can use various values for discount rate including:

- inflation
- interest rate
- shareholder’s expected rate of return
- an industry benchmark rate of return
- cost of capital (e.g. interest rate, loan payments, or dividend payments)
- expected rate of return for alternative investments e.g. the risk-free rate

**4. Number of periods. **This is the duration of the project or the payback period i.e. the amount of time it will take the project to pay for itself. If you want to invest in a startup and expect to recover your investment in 3 years, your number of periods is 3.

## The Net Present Value Formula

A simplified version of the net present value formula is:

*Today’s value of expected cash flows − Today’s value of invested cash*

To calculate NPV using a **single projected cash flow**, you can use the following formula.

If you have** future cash flows for each year of the project**, you can calculate the present value of the investment for each year and add them together using the formula below, where* n* is the year e.g. 1 year from the start of the project is 1.

## Net Present Value Calculator

Ready to see what your potential investments could yield? Our Net Present Value calculator simplifies complex calculations by instantly evaluating the profitability of your proposed projects.

Just input your projected cash flows, the required return, the number of time periods, and initial investment:

### Bonus: Calculating NPV Using Excel

It is useful to understand the concepts behind these formulae. However, most financial analysts and project managers will calculate net present value using the NPV function in Excel or other spreadsheet software.

You can see how this is done in the example below.

Net cash flow for periods 1,2, and 3 are discounted using the discount rate and added together. The original investment ($100) is subtracted to find the net present value of $36.43.

### NPV Formula: Pros and Cons

**Pros:**

**Accounts for Time Value of Money:**NPV includes the discount rate, which considers the potential returns from alternative investments, ensuring that time value is integrated into financial decisions.**Comprehensive Evaluation:**Offers a holistic view by including all expected cash inflows and outflows, providing a detailed assessment of profitability.**Decision Making:**Helps businesses prioritize projects by comparing the profitability of different investments, making it easier to allocate resources efficiently.**Flexibility in Analysis:**Can be adjusted for different scenarios using different discount rates, allowing for versatile and dynamic financial planning.

**Cons:**

**Dependence on Estimates:**Relies heavily on projected cash flows and discount rates, which can be uncertain and subject to inaccuracies.**Complexity:**Calculating NPV can be complex, especially with investments that have multiple cash flows spread over many periods.**Ignores Non-financial Factors:**NPV focuses solely on financial returns and does not consider qualitative factors like environmental impact or brand reputation.**Requires a Discount Rate:**Determining an appropriate discount rate can be challenging and subjective, affecting the accuracy of the NPV calculation.

## What Represents A Good Net Present Value?

- A
**positive NPV**means the project is expected to be profitable. In investing terms, a positive net present value means the investment will generate returns that outweigh the costs. - A
**negative NPV**suggests the project will not make a profit. - An
**NPV of zero**indicates that the project will break even meaning the cash inflow will equal exactly the sum of the cash outflow and the initial investment.

However, a venture or investment with a negative NPV may still be worthwhile if it offers **intangible or non-financial value**.

**For example:** You may choose to purchase a home for stability. A business may choose to invest in a project to boost its brand image or satisfy internal stakeholders.

### Is A Higher or Lower NPV Better?

A higher NPV is generally better as it indicates that the investment’s returns significantly exceed the costs, reflecting a highly profitable venture. Conversely, a lower or negative NPV suggests that the investment may not cover its costs, indicating potential losses or underperformance.

## NPV Calculation Examples

Let’s take a look at a few examples, starting with one that uses just one cash flow figure.

### Example 1

A chocolate company is considering purchasing a new machine for its factory. It will cost $100k but it will be faster than the current machine so it should generate extra future cash flows of $15k per year. The machine will last for 10 years. Say the average discount rate for the confectionery industry is 20%.

*NPV = (15,000 x10)/(1 + 0.2) – 100,000 = 25,000*

This means the investment is projected to generate $25k in returns in today’s money.

### Example 2

A company is choosing between two projects. Both projects will take 5 years to complete. Project A requires an initial investment of $200k. Project B requires an initial investment of $500k. The discount rate is the company’s average cost of capital which is 6%.

Project A |
Project B |
|||

Year |
Cash Flow |
Present Value |
Cash Flow |
Present Value |

0 |
-200,000 | -200,000 | -500,000 | -500,000 |

1 |
-30,000 | -28,302 | 20,000 | 18,868 |

2 |
20,000 | 17,800 | 20,000 | 17,800 |

3 |
100,000 | 83,962 | 210,000 | 176,320 |

4 |
100,000 | 79,209 | 210,000 | 166,340 |

5 |
100,000 | 74,726 | 210,000 | 156,924 |

NPV |
27,395 | 36,252 |

**Please Note:** The table shows the projected future cash flows for each project for each year. Year zero is the present day so it shows the initial investment as a cash outflow. The cash flow increases with each year which suggests there are expenses involved in getting the projects off the ground. The next column shows the cash flow values discounted to their present value.

**For example:** Project A generates -$30k in year 1.

*Present value = Net cash flow/ (1+ Discount rate) ^n*

*= -30,000 /(1+ 0.06) ^1 *

*= -30,000 /1.06*

= -28,302

Therefore the present value of the cash flow for year 1 is -$28,302.

The net present value is calculated by adding together the discounted cash flows, minus the initial investment.

Both projects have a **positive** net present value which means they are projected to be profitable. Project B has a **higher net present value** but it also requires a much **larger upfront investment **which may make it less appealing.

**Remember:** Decision makers will also need to consider** contextual factors** like competitor behavior and the broader business strategy before choosing which project to pursue.

## Advantages of Net Present Value

The biggest advantage of net present value is that it accounts for the **time value of money**.

It provides a concrete, **dollar value** which makes it easy to compare different projects and assess profits relative to the initial investment.

It’s also useful that this metric accounts for the **cost of capital** i.e. the interest rates, dividends, or loan payments.

## Disadvantages of Net Present Value

The downside of net present value is that it **relies on some guesswork**. Projected cash flow is rarely guaranteed and interest rates and inflation can change, making your discount rate inaccurate.

Net present value also **does not account for real-world factors**. Future cash flows are impacted by everything from consumer trends to the price of gas and all sorts of other things that are difficult to quantify. Therefore, net present value should be viewed alongside relevant contextual information.

## Other Useful Profitability Metrics Related to NPV

Net present value is not the only way to assess the profitability of a project.

Here are three additional ones:

### 1. Return on Investment (ROI)

ROI is the **net value generated by a project** or investment over a given period. Unlike net present value, ROI does not account for the time value of money. However, ROI is simpler to calculate.

Say you invest $2k in your friend’s online hat boutique. A year later, you sell the shares for $2.5k.

*ROI = 500/2000 x 100 = 25%*

ROI can be calculated for the full duration of a project, the payback period, or any chosen period.

One kind of ROI is the **accounting rate of return (ARR)**. ARR measures the annual returns generated by an investment relative to the initial cost.

### 2. Payback Method

The payback method answers the question: **How long will it take to recover the initial investment?** The period of time it takes to recover your investment is called the payback period. You can calculate it by dividing the cost of investment by average annual cash flow.

Say you have a restaurant and you move to bigger premises at an upfront cost of $500k. The restaurant can now generate an extra $100k cash flow per year.

*Payback period = 500/100 = 5 years*

Unlike net present value, payback period does not account for the time value of money.

### 3. Internal Rate of Return (IRR)

The internal rate of return is the discount rate that makes the net present value equal to the initial investment. It can be thought of as the **expected annual rate of growth of an investment**.

To calculate IRR, use the net present value formula but **set the NPV to zero** and solve for the discount rate. The calculation is a bit complex but it can be drastically simplified by using Excel or similar software.

The IRR is particularly useful for comparing potential projects of different sizes. A **higher IRR is better** because it indicates a higher expected rate of growth.

A project will be profitable if the IRR is **higher than the company’s weighted cost of capital** (WACC). Firms may also set a required rate of return – the minimum IRR that would make the project worthwhile.

#### NPV vs. Internal Rate of Return (IRR) Compared

NPV and IRR are both used to assess the profitability of investments, but they focus on different aspects.

While **NPV** gives the net value of an investment in dollar terms, IRR identifies the rate of return at which the net present value becomes zero.

**IRR** is useful for comparing the profitability rates of various projects, whereas NPV provides a direct profitability value that can influence investment decisions more directly.

**Pro Tip**: Consider using NPV alongside other financial metrics like IRR (Internal Rate of Return) or ROI (Return on Investment) for a comprehensive analysis of your investment’s performance.

## Why Are Future Cash Flows Discounted in NPV?

Future cash flows are discounted in NPV calculations to account for the time value of money, reflecting the principle that money available today is worth more than the same amount in the future due to its potential earning capacity.

Discounting helps to normalize future earnings to present-day values, providing a more accurate representation of an investment’s true financial impact.

## Wrapping Up: Always Consider the Time Value of Your Money

An investment or project with high projected returns may look appealing but you can only truly evaluate profitability when you’ve accounted for the **opportunity cost of giving up cash today**.

Whether you’re setting aside money for your retirement, scoping out an investment opportunity, or making a big purchase for your business, the net present value calculator will help you make choices to **maximize your returns**.