Net Present Value (NPV)
Net present value, or NPV, is the value today of an investment's expected future cash flows, discounted at a required rate of return, minus the initial outlay. It converts money received at different times into a single comparable figure in today's terms. A positive NPV means the investment is expected to add value; a negative NPV means it destroys value.
Worked example
An investment costs $1,000 today and returns $600 in year 1 and $600 in year 2, at a 10% discount rate. PV of year 1 = $600 ÷ 1.10 = $545.45. PV of year 2 = $600 ÷ 1.21 = $495.87. NPV = $545.45 + $495.87 − $1,000 = $41.32.
Why it matters
NPV is the cornerstone of capital budgeting because it accounts for both the time value of money and the size of every cash flow. The standard rule is to accept any project with a positive NPV. The common pitfall is the discount rate: a small change in it can flip an NPV from positive to negative, so the rate must reflect the project's true risk.
Frequently asked questions
What does a positive NPV mean?
A positive NPV means the investment is expected to earn more than the required rate of return, adding value after recovering its initial cost. Higher positive NPV generally indicates a more attractive project.
How is NPV different from IRR?
NPV gives a dollar amount of value created at a chosen discount rate, while IRR gives the single rate at which NPV equals zero. NPV is usually preferred when ranking mutually exclusive projects.
Related terms: Present Value, Internal Rate of Return (IRR), Discount Rate