Net Present Value (NPV)

Reviewed by Will Kenton

Updated Jun 25, 2019

What is Net Present Value (NPV)?

Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project.

The following formula is used to calculate NPV:

NPV=∑t=1nRt(1+i)twhere:Rt=Net cash inflow-outflows during a single period ti=Discount rate 
or return that could be earned inalternative investmentst=Number of timer periods\begin{aligned
} &NPV = \sum_{t = 1}^n \frac { R_t }{ (1 + i)^t } \\ &\textbf{where:} \\ &R_t=\text{Net cash
inflow-outflows during a single period }t \\ &i=\text{Discount rate or return that could be earned
in} \\ &\text{alternative investments} \\ &t=\text{Number of timer periods} \\ \end{aligned}
NPV=t=1∑n(1+i)tRtwhere:Rt=Net cash inflow-outflows during a single period ti=Discount rate 
or return that could be earned inalternative investmentst=Number of timer periods

If you are unfamiliar with summation notation – here is an easier way to remember the concept
of NPV:

NPV=TVECF−TVICwhere:TVECF=Today’s value of the expected cash flowsTVIC=Today’s va
lue of invested cash\begin{aligned} &\textit{NPV} = \text{TVECF} - \text{TVIC} \\
&\textbf{where:} \\ &\text{TVECF} = \text{Today's value of the expected cash flows} \\
&\text{TVIC} = \text{Today's value of invested cash} \\ \end{aligned}
NPV=TVECF−TVICwhere:TVECF=Today’s value of the expected cash flowsTVIC=Today’s va
lue of invested cash

A positive net present value indicates that the projected earnings generated by a project or
investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is
assumed that an investment with a positive NPV will be profitable, 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 only investments with positive NPV values should be considered.

Apart from the formula itself, net present value can be calculated using tables, spreadsheets,
calculators, or Investopedia’s own NPV calculator.
What is Net Present Value (NPV)?
Net Present Value (NPV) is the value of all future cash flowsStatement of Cash FlowsThe
Statement of Cash Flows (also referred to as the cash flow statement) is one of the three key
financial statements that report the cash generated and spent during a specific period of time
(e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income
statement and balance sheet (positive and negative) over the entire life of an investment
discounted to the present. NPV analysis is a form of intrinsic valuation and is used extensively
across financeCorporate Finance OverviewCorporate Finance involves the financial aspect of
businesses wherein sources of funds are determined, existing assets invested, excess profits
distributed. Corporate finance also includes the tools and analysis utilized to prioritize and
distribute financial resources. The ultimate purpose of corporate finance is to and accounting for
determining the value of a business, investment security, capital project, new venture, cost
reduction program, and anything that involves cash flow.

NPV Formula

The formula for Net Present Value is:

Where:

 Z1 = Cash flow in time 1

 Z2 = Cash flow in time 2
 r = Discount rate
 X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth. It is an all-encompassing metric, as it takes into account all revenuesSales
RevenueSales revenue is the income received by a company from its sales of goods or the
provision of services. In accounting, the terms "sales" and "revenue" can be, and often are, used
interchangeably, to mean the same thing. Revenue does not necessarily mean cash received.,
expenses, and capital costs associated with an investment in its Free Cash Flow (FCF)Free Cash
Flow (FCF)Free Cash Flow (FCF) measures a company’s ability to produce what investors care
most about: cash that's available be distributed in a discretionary way.

In addition to factoring all revenues and costs, it also takes into account the timing of each cash
flow that can result in a large impact on the present value of an investment. For example, it’s
better to see cash inflows sooner and cash outflows later, compared to the opposite.

Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust
for the risk of an investment opportunity, and (2) to account for the time value of money (TVM).

The first point (to adjust for risk) is necessary because not all businesses, projects, or investment
opportunities have the same level of risk. Put another way, the probability of receiving cash flow
a US Treasury bill is much higher than the probability of receiving cash flow from a young
technology startup.

To account for the risk, the discount rate is higher for riskier investments and lower for a safer
one. The US treasury example is considered to be the risk-free rate, and all other investments are
measured by how much more risk they bear relative to that.

The second point (to account for the time value of money) is required because due to inflation,
interest rates, and opportunity costs, money is more valuable the sooner it’s received. For
example, receiving $1 million today is much better than $1 million received five years from now.
If the money is received today, it can be invested and earn interest, so it will be worth more than
$1 million in five years’ time.

Example of Net Present Value (NPV)

Let’s look at an example of how to calculate the net present value of a series of cash
flowsValuationFree valuation guides to learn the most important concepts at your own pace.
These articles will teach you business valuation best practices and how to value a company using
comparable company analysis, discounted cash flow (DCF) modeling, and precedent
transactions, as used in investment banking, equity research,. As you can see in the screenshot
below, the assumption is that an investment will return $10,000 per year over a period of 10
years, and discount rate required is 10%.

 
 

The final result is that the value of this investment is worth $61,446 today. It means a rational
investor would be willing to pay up to $61,466 today to receive $10,000 every year over 10
years. By paying this price, the investor would receive an internal rate of returnInternal Rate of
Return (IRR)The Internal Rate of Return (IRR) is the discount rate that sets the net present value
of an investment equal to zero. This guide to calculating IRR will give several examples and who
why it's used in capital budgeting, private equity and other areas of finance and investing. If IRR
is greater than cost of capital, (IRR) of 10%. By paying anything less than $61,000, the investor
would earn an internal rate of return that’s greater than 10%.

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NPV Functions in Excel

Excel offers two functions for calculating net present value: NPV and XNPV. The two functions
use the same math formula shown above, but save an analyst the time for calculating it in long
form.

The regular NPV function =NPV() assumes that all cash flows in a series occur at regular
intervals (i.e. years, quarters, month) and doesn’t allow for any variability in those time period.

The XNPV function =XNPV() allows for specific dates to be applied to each cash flow so they
can be at irregular intervals. The function can be very useful as cash flows are often unevenly
spaced out, and this enhanced level of precision is required.

Internal Rate of Return (IRR) and NPV

The internal rate of return (IRRInternal Rate of Return (IRR)The Internal Rate of Return (IRR) is
the discount rate that sets the net present value of an investment equal to zero. This guide to
calculating IRR will give several examples and who why it's used in capital budgeting, private
equity and other areas of finance and investing. If IRR is greater than cost of capital,) is the
discount rate at which the net present value of an investment is equal to zero. Put another way, it
is the compound annual return an investor expects to earn (or actually earned) over the life of an
investment.

For example, if a security offers a series of cash flows with an NPV of $50,000 and an investor
pays exactly $50,000 for it, then the investor’s NPV is $0. It means they will earn whatever the
discount rate is on the security. Ideally, an investor would pay less than $50,000 and therefore
earn an IRR that’s greater than the discount rate.

Typically, investors and managers of business look at both NPV and IRR in conjunction with
other figures when making a decision. Learn about IRR vs XIRR in ExcelXIRR vs IRRWhy use
XIRR vs IRR. XIRR assigns specific dates to each individual cash flow making it more accurate
than IRR when building a financial model in Excel. The Internal Rate of Return is the discount
rate which sets the Net Present Value of all future cash flow of an investment to zero. Use XIRR
over IRR.

Negative vs Positive Net Present Value

If the net present value of a project or investment, is negative it means the expected rate of return
that will be earned on it is less than the discount rate (required rate of return or hurdle rateHurdle
Rate DefinitionA hurdle rate is the rate of return that must be achieved before accepting and
funding an investment project. Hurdle rates are used in financial modeling to calculate NPV. If
IRR > Hurdle Rate then the investment creates value. The rate is determined by assessing the
cost of capital, risks involved, opportunity cost). This doesn’t necessarily mean the project will
“lose money.” It may very well generate accounting profit (net income), but, since the rate of
return generated is less than the discount rate, it is considered to destroy value.  If the NPV is
positive, it creates value.

Applications in Financial Modeling

NPV of a Business

To value a business an analyst will build a detailed discounted cash flow DCF modelDCF Model
Training Free GuideA DCF model is a specific type of financial model used to value a business.
DCF stands for Discounted Cash Flow, so the model is simply a forecast of a company’s
unlevered free cash flow discounted back to today’s value.  This free DCF model training guide
will teach you the basics, step by step with examples and images in Excel.  This financial model
will include all revenues, expenses, capital costs, and details of the business.  Once the key
assumptions are in place, the analyst can build a five-year forecast of the three financial
statementsThree Financial StatementsThe three financial statements are the income statement,
the balance sheet, and the statement of cash flows. These three core statements are intricately
linked to each other and this guide will explain how they all fit together. By following the steps
below you'll be able to connect the three statements on your own. (income statement, balance
sheet, and cash flow) and calculate the free cash flow of the firm (FCFF)ValuationFree valuation
guides to learn the most important concepts at your own pace. These articles will teach you
business valuation best practices and how to value a company using comparable company
analysis, discounted cash flow (DCF) modeling, and precedent transactions, as used in
investment banking, equity research,, also known as the unlevered free cash flow. Finally, a
terminal value is used to value the company beyond the forecast period, and all cash flows are
discounted back to the present at the firm’s weighted average cost of capital. To learn more,
check out CFI’s free detailed financial modeling course.

NPV of a Project
To value a project is typically more straightforward than an entire business. A similar approach
is taken, where all the details of the project are modeled into Excel, however, the forecast period
will be for the life of the project and there will be no terminal value. Once the free cash flow is
calculated, it can be discounted back to the present at either the firm’s WACCWACCWACC is a
firm’s Weighted Average Cost of Capital and represents its blended cost of capital including
equity and debt. The WACC formula  is = (E/V x Re) + ((D/V x Rd)  x  (1-T)). This guide will
provide an overview of what it is, why its used, how to calculate it, and also provides a
downloadable WACC calculator or the appropriate hurdle rate.

Drawbacks of Net Present Value

While net present value (NPV) is the most commonly used method for evaluating investment
opportunities, it does have some drawbacks that should be carefully considered.

Key challenges to NPV analysis include:

  A long list of assumptions has to be made
 Sensitive to small changes in assumptions and driversValuation Modeling in
ExcelValuation modeling in Excel may refer to several different types of analysis,
including discounted cash flow (DCF), comparable trading multiples, precedent
transactions, and ratios such as vertical and horizontal analysis.
 Easily manipulated to produce the desired output
 May not capture second- and third-order benefits/impacts (i.e. on other parts of a
business)
 Assumes a constant discount rate over time
 Accurate risk-adjustment is challenging to perform (hard to get data on correlations,
probabilities)

Additional Resources

Net Present Value (NPV) is the most detailed and widely used method for evaluating the
attractiveness of an investment. Hopefully, this guide’s been helpful in increasing your
understanding of how it works, why it’s used, and the pros/cons.

CFI is the official provider of the Financial Modeling & Valuation Analyst certification
programFMVA® CertificationThe Financial Modeling & Valuation Analyst (FMVA)®
accreditation is a global standard for financial analysts that covers finance, accounting, financial
modeling, valuation, budgeting, forecasting, presentations, and strategy.