Wednesday, September 21st, 2016
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows.
It is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment. In other words, the amount invested is compared to the future cash amounts after they are discounted by a specified rate of return.
A simple way to think about the net present value is:
NPV = Present Value (earnings) – Present Value (costs)
A positive net present value indicates that the projected earnings generated by a project or investment (in present money) exceeds the anticipated costs (also in present money). Generally, an investment with a positive NPV will be a profitable one, and an investment with a negative NPV will result in a net loss.
This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values.
Determining the value of a project is challenging because there are different ways to measure the value of future cash flows. Because of the time value of money (TVM), money in the present is worth more than the same amount in the future. This is both because of earnings that could potentially be made using the money during the intervening time and because of inflation.
Summing-up: Investments with a positive net present value would be acceptable. Investments with a negative net present value would be unacceptable.