NPV, or “Net Present Value,” is used to evaluate a project or investment’s present-day worth. Also known as Discounted Cash Flow (DCF), calculating NPV is a common economic and finance formula intended to determine compound interest in reverse. The fundamental principle behind this formula is that a dollar received in the future is worth less than a dollar received today,
The purpose of NPV
Calculating net present value is one of the most reliable and popular formulas used in capital budgeting simply because it accounts for the time value of money by using discounted cash flows. Before deciding to participate in a company, a company or investor first calculates how profitable that endeavor will be. The principle of NPV is similar to that of return on investment (ROI) in that a positive value would make for a good investment, but the formula is quite different and measures cash flows against a discount rate.
Determining NPV is dependent on a variety of factors. To calculate NPV, you must first identify all cash flows associated with a project or investment and the times during which they will occur. Cash flows can be both negative — when money is spent — and positive — when money is received — but the real difficult point comes with determining an interest rate.
To effectively gauge NPV, you must set an appropriate interest rate, or discount rate, which will effectively reduce future cash flow to an equivalent present-day value. Once a correct percentage is identified, you then simply add together the present values of both positive and negative cash flows to identify the actual money.
To effectively demonstrate how NPV works, imagine you made an investment of $1,000 in the stock market with a discount rate of 10 percent. You would then expect to receive $110 by the start of the second year and have a total balance of $1,200 by the start of the third year. Calculating the NPV would then equate to the following:
- Year 1 cash flow: -$1,000
- Year 2 present value cash flow: $110/1.10 = $100
- Year 3 present value cash flow: $1,200/(1.102) = $1,200/1.21 = $991.74
- Final NPV: -$1,000 + $100 + 991.74 = $91.74
So while you may have received $200 in return to the investment, that money equates to a present value of $91.74. Based on the fact that this scenario returns a positive value, it is considered a good investment opportunity and will return a significant amount of money to the investor.