What Is NPV?
The Net Present Value (NPV) is a method that is primarily used for financial analysis in determining the feasibility of investment in a project or a business. It is the present value of future cash flows compared with the initial investments.
As an organization expands, it needs to take important decisions which involve immense capital investment.
Every investment would have cash outflows and cash inflows. There is the cash that is required to make the investment and (hopefully) the return.
In order to see whether the cash outflows are less than the cash inflows (i.e., the investment earns a positive return), the investor aggregates the cash flows. Since cash flows occur over a period of time, the investor knows that due to the time value of money, each cash flow has a certain value today. Thus, in order to sum the cash inflows and outflows, each cash flow must be discounted to a common point in time.
Calculation For Net Present Value
The net present value (NPV) is simply the sum of the present values (PVs) and all the outflows and inflows:
NPV = PV Inflows+ PV Outflows
PV = Present Value
Don’t forget that inflows and outflows have opposite signs; outflows are negative.
Also recall that Present Value (PV) is found by the formula:
PV = FV(1+i)tPV=FV(1+i)t
FV is the future value (size of each cash flow),
i is the discount rate, and
t is the number of periods between the present and future.
The PV of multiple cash flows is simply the sum of the PVs for each cash flow.
The sign of NPV can explain a lot about whether the investment is good or not:
NPV > 0: The PV of the inflows is greater than the PV of the outflows. The money earned on the investment is worth more today than the costs, therefore, it is a good investment.
NPV = 0: The PV of the inflows is equal to the PV of the outflows. There is no difference in value between the value of the money earned and the money invested.
NPV < 0: The PV of the inflows is less than the PV of the outflows. The money earned on the investment is worth less today than the costs, therefore, it is a bad investment.
Thus, as the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.