Net Present Value (NPV)

Traditional valuation method. Explanation of Net Present Value.

Net Present Value (NPV)What is Net Present Value? Definition

The Net Present Value (NPV) of an investment (project) is the difference between the sum of the discounted cash flows which are expected from the investment, and the amount which is initially invested. It is a traditional valuation method (often for a project) used in the Discounted Cash Flow measurement methodology, whereby the following steps are undertaken:

 

Steps in the calculation of Net Present Value

  1. Calculation of expected free cash flows (often per per year) that result out of the investment
  2. Subtract / discount for the cost of capital (an interest rate to adjust for time and risk)

The intermediate result is called: Present Value.

  1. Subtract the initial investments

The end result is called: Net Present Value.

 

Therefore NPV is an amount that expresses how much value an investment will result in. This is done by measuring all cash flows over time back towards the current point in present time.

 

If the NPV method results in a positive amount, the project should be undertaken.

 

Limitations of Net Present Value

  • Although NPV measurement is widely used for making investment decisions, a disadvantage of NPV is that it does not account for flexibility / uncertainty after the project decision. See Real Options for more information.
  • Also NPV is unable to deal with intangible benefits. This inability decreases its usefulness for strategic issues and projects. See IC Rating for more information.

Book: S. David Young, Stephen F. O'Byrne - EVA and Value-Based Management: A Practical Guide.. -

Book: Aswath Damodaran - Investment Valuation: Tools and Techniques for Determining the .. -

Book: James R. Hitchner - Financial Valuation: Applications and Models -

 

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Recent User Comments
Rev David Commey - Ghana-W/A Corporate Finance "Halky company is considering buying a carrier for $8million.Forecasted revenues are $5 million a year and operating cost is $4 million.Another model costing $2 million would be required after the fifth and tenth years.After 15 years, the carrier would be sold for a scrap of $15 million.If discount rate is 8%, what is the carrier's Net Present Value?"    0
Natasha - Greece Comparing NPVs "If I have 2 investments,and have to compare the NPV of both. Which one I prefer? With the biggest NPV?"    5
Mohon - Bangladesh NPV "In calculating NPV when initial investment is not mentioned what should i do? Only cost and benefit from year 1 is given. What would be the power of (1+discount rate) 1 or 0?"    -1
Bruce - USA NPV of Partial Payments "Suppose a business sells an average of $ 1000 per month to a group of 200 customers on Net 30 terms. What would be the financial benefit to the seller if those customers each paid 1/30th of the invoice each day for 30 days.
The situation is one where the fluid product is consumable (in a drum) and lasts for about 30 days."		    0
Geert van der Horst - Netherlands NPV assumes Certainty of Cash Flows "When using the Net Present Value method be careful: this calculation assumes certainly in the forecasted future cash flows. For strategic longer term projects this assumptions is often not valid in today's volatile markets and uncertain business environment."    1
Best User Comments
Jacob - USA Re-evaluating an investment decision "Question: I am re-evaluating an investment decision from 2004 - - where the initial investment was made. If I wanted to look at the investment today would I need to take the future value of the past CFs and investment into todays dollars and then re run my DCF model. I believe this is the right approach. Thoughts?"    38

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Compare with Net Present Value: Internal Rate of Return  |  Payback Period  |  Cost-Benefit Analysis  |  Total Cost of Ownership  |  CAGR  |  Cost of Equity

 

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  ● Isaac Nyamanza (Zimbabwe) Timing with NPV "Revalue the initial investment to its present value and discount the future cash flows to get NPV as at now. This will give you a better position for decision making."
  ●  (Pakistan) Think now when you think about decision making. "As an opinion there is no problem to take past CFs for the re-evaluation, but the decision made in the past was probably valid in that situation. So think now to see whether some "being things remain equal" is still valid or not. See cash flows in the current scenarios for technical, economical, social & legal feasibility."
  ● kssubramanian (india) DCF "The relevant things are only to be taken. The present value of the investment has to be established based on its worth today based on market and the future cash flows will have to be reassessed and discounted in todays cost of capital"
  ● Abubakar Umar (Nigeria) Re-evaluating an Investment Decision "It is better to consider the past cash flows up to 2004 and adjust other variables to begin your analysis of future cash flows. That way, you are considering all the possible cash flows associated with the project.."
  ● mahrukh (pakistan) the context "For the sake of decision making ignore all past expenditure and for the sake of re-evaluation,context and the appropriate time horizon are important,past CFs were relevant in the past and in that particular context only"
  ● mac (Uganda) Base on the past "I really think thats a great idea, you've got to take into consideration how things were in the past and then establish a link with the present so as to determine the future"

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