Net Present Value (NPV)

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Traditional valuation method. Explanation of Net Present Value.

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.

3. 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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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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