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
Calculation of expected free cash
flows (often per per year) that result out of the investment
Subtract / discount for the cost of capital (an interest rate to adjust
for time and risk)
The intermediate result is called: Present Value.
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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