Net Present Value: A Definition

When considering an investment, there are a variety of factors that come into play when deciding if this will be profitable. Many investments, like rental real estate or stock dividends, involve regular payments into the future. Because of inflation, money now is worth money in the future and it can be difficult to determine whether an investment is worth making. The net present value (NPV) is a calculation that helps determine the value of an investment that involves future payments.

What Is Net Present Value (NPV)?

Net present value is a method used to measure the future cash flow of an investment based on a specified discount rate during different times. The NPV calculates an investment by adding the present values of all cash inflows and outflows. Knowing the net present value can help calculate the return on investment for a particular investment.

How Net Present Value Works

The net present value calculates the present value and future value of each cash flow associated with an investment. The way that NPV works is to look at the values for each cash inflow and cash outflow of the investment. Then you can compare the present value of the cash inflows to the present value of the cash outflows.

If the net present value of an investment is positive, that means that the present value of the cash flow is greater than the present value of the cash outflows. Generally speaking, having a positive NPV means that the investment will return money over the duration that money is invested.

What Is Net Present Value Used For?

Net present value is used to help determine the value of an investment and it uses capital budgeting to analyze its profitability. It takes into account all of the incoming revenues and other costs over time.

How To Calculate Net Present Value

To calculate the NPV, you can use the net present value formula to calculate the present value of each of the inflows and outflows for a given investment.

Net Present Value Formula

NPV = (Cash flow / ( 1 + i )^t ) – initial investment

i  = discount rate

t  = number of period (usually in years)

To use the NPV calculation, first take the cash flow for a given period, and divide that by (1 + the discount interest rate) to the power of the number of time periods. Then subtract the amount of the initial investment to find the net present value for this investment.

As an example, say that you have an investment that requires an initial investment of $9,000 and pays out $2,500 per year over a 4-year period. On the surface, it may seem that this has a positive net present value since you invest $9,000 and receive $10,000 back over the life of the investment. But this does not account for the fact that $9,000 today is worth more than $10,000 in four years because of expected inflation.

To calculate the net present value, first you must choose a discounted interest rate. This is the rate that you might earn if you invested your money in an alternative example. For this example, we'll use 5%. The $10,000 you receive over the life of your investment is divided by 1.05 (1 + the interest rate) to the fourth power (since the investment lasts 4 years). You subtract the initial investment ($9,000) from this number to get a net present value of -$772.98.

NPV = ($10,000 / ( 1 + .05 )⁴ ) – $9,000

NPV = 8227.025 – 9000

NPV = - 772.98

If the investment has multiple expenses or returns, do this net present value calculation for each inflow and outflow, using a positive number for income received and a negative number for each expected expense. The net present value is the sum of each of these present value calculations.

NPV Vs. IRR

The internal rate of return (IRR) of an investment is another way to determine whether a given investment is profitable. The internal rate of return of an investment is the discount rate that makes the net present value zero. The IRR is calculated as a percentage as opposed to the NPV, which is expressed as a dollar amount. Another way to think of the difference between NPV and IRR is that when calculating the NPV, you make an assumption on the discount rate. When calculating IRR, you set the NPV to $0 and calculate the discount rate itself.

NPV Vs. PV

The present value (PV) of an investment is the current value of a particular investment. To calculate the NPV, you need to find the present value of each of the inflows and outflows of the investment in question. Taking the difference between the present value of the inflows and the present value of the outflows determines the net present value.

Pros and Cons Of Net Present Value

There are pros and cons of using net present value as a way to evaluate an investment.

Pros

Some of the pros of net present value are that it:

• Considers the time value of money – money today is worth more than money in the future
• Determines investment value
• Measures profitability
• Provides a comprehensive method to gauge future cash flow

Cons

Some of the cons of net present value are that it:

• Makes numerous assumptions
• Could result in predicting errors
• Hinges on using a correct discount rate to determine the present value
• Is hard to compare different types of investments or projects if they are over differing lengths of time

Net Present Value FAQs

What does ‘net present value’ mean?

Net present value comes from the idea that money is worth more today than in the future, due to inflation. How much future payments are discounted depends on the discount rate, which can vary by person, investment and many other sources. This discount rate judges the value of money at any given time.

What is a good NPV?

Any positive net present value is good, in that the present value of the money coming in is greater than the expenses over the duration of the investment. Besides looking for a positive net present value, it's best to use NPV as a way to compare the feasibility of two or more different investments.

What does a negative NPV mean?

If an investment has a negative NPV it means that the returns that come in over time are worth less than the initial investment. While that doesn't necessarily mean that the investment should not be pursued, it may be less attractive than other investments with positive NPVs.

The Bottom Line

Using the net present value method can help determine an investment’s profitability. To calculate the net present value, add up the present value of all incoming payments over the course of the investment. Then subtract the present value of any outflows. To learn more about the net present value, you'll also want to understand what the rate of return means.