Net Present Value (NPV)

What is Net Present Value (NPV)?

Net present value (NPV) is a financial metric used to evaluate the profitability of an investment or project. It represents the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Putting that into real-world language, we can say it like this:

Net present value is how much money we’ll get back (over time), minus how much we need to spend (today) to make that happen.

Note: net present value is a single, headline number. If it’s calculated over a five-year term, a positive NPV could mean that an investment requiring an upfront disbursement of cash today will keep being a drain on your reserves for the next 36 months, only to become profitable after that time. This kind of thing is why it’s important to read footnotes!

NPV’s Importance in Capital Budgeting

The future, while not as certain as the present, is at least predictable. This difference between the definite and the expected leads to two main systems of accounting:

• In accrual-basis accounting, all assets, liabilities, income, and expenses are treated the same – according to their nominal value, whenever this may be realized.
• Using cash-basis accounting, by contrast, the only thing that matters is real money coming in and flowing out right now.

There needs to be a way to relate one to the other: for example, all companies have both cash flow and income statements, with liquidity being the conceptual bridge between the two.

For capital budgeting purposes, the equivalent of liquidity is net present value.

What NPV Tells You

One important thing you may have noticed from our definition of net present value is that it’s always expressed as a dollar amount. It’s not a percentage – and those dollars are each worth the same amount.

NPV Formula

Even if Greek letters give you the heebie-jeebies, the net present value is a cinch to calculate if you have all the needed data:

How to Calculate NPV

Technically, the net present value calculation is a time series: to get the answer, you need to know or estimate the cash flow for each period. When determining NPV, these intervals may be months, quarters, or even years.

Components of NPV

When using the net present value formula, you have to make sure that the value you assign to each of these variables is reasonable, justifiable, and as accurate as the situation permits.

The letter “n“, wherever it appears, corresponds to the first, second, etc. time period – the one you’re crunching the numbers on.

T refers to the number of periods. If the scope of the investment or project is one year and NPV is calculated on a monthly basis, T will be equal to 12.

Cn, simply means the total cash flow during the period denoted by n. This may be positive or negative and will normally vary over time.

C0 is the upfront cost – the amount of money paid out before the first period in which we see ordinary cash flow.

r is the expected (or required) discount rate. Investors often use inflation as a kind of first approximation for r.

Positive NPV vs. Negative NPV

Net present value is an example of what a statistician would call a “summary measure”, like an average. Though a lot of information goes into calculating it, the result is a single, bottom-line number that enables managers and investors to determine, at a glance, whether an idea is good or bad. If “good”, they will presumably spend some time delving into the details.

NPV vs. Internal Rate of Return (IRR)

You will often hear about another accounting concept closely related to NPV, called internal rate of return (IRR). Both give a more accurate picture of a capital investment’s attractiveness than a simple return on investment (ROI), which doesn’t explicitly account for the fact that next year’s dollars are worth less than this year’s.

IRR, however, turns the equation we’ve just encountered on its head by assuming a zero return. This just means using nothing for net present value and solving for r, the discount rate, instead.

In other words, IRR answers the question: “How much does the investment have to yield to just break even when adjusting for inflation (or, more generally, the future value of money)?” It is expressed as a percentage.

NPV Example

Net present value is often used as a primary cost/benefit analysis tool within companies. If we spend x today, will we come out ahead in due time?

Bob is considering buying an apartment using a personal loan to finance $100,000 of the purchase price. He will rent it out for 10 years and, once the outstanding loan balance has been repaid, expects to clear $20,000 in capital gains.

Ignoring all kinds of expenses:

Loan payments – 1,000

Maintenance – 200

Rent – 1,100

As these figures are monthly, we have:

T = 120, Co = 100,000, Cn = (1,100 – 1,200) = -100 (assumed to be the same during every period except the last, when the property is sold, yielding C120 = 120,000 – 100).

For the discount rate r, let’s just use a CPI figure of 3.5%.

This equals an NPV of about negative $25,000.

This makes sense: the value of the initial $100,000 outlay, the $20,000 profit at the end of 10 years, and the $12,000 in negative cash flow in the meantime aren’t measured in the same dollars!

NPV Pros and Cons

One drawback of looking only at a project’s net present value is that it doesn’t give you the whole cash flow picture. Potentially, you may have to keep on shelling out cash well into the future just to sustain the project or investment (a small, growing business, for instance). This doesn’t impact a company like General Electric or Blackrock all that much, but may mean a great deal to a small, independent investor.

On the positive side, the very definition of NPV emphasizes the word present. Let’s use a five-year horizon and allow the specter of inflation into our minds: at 3.5% CPI and assuming you get your money back without any net loss or profit, the buck you invest today only comes to 86.7 cents.

The Bottom Line

We all know that money loses value over time; investors use discount rates (inflation or otherwise) every day. Getting a gut feel for how this works is, however, difficult. The concept of net present value, stated as it is in dollars and cents, makes it easy to think about longer timeframes. It does not, however, make any provision for unforeseen events or bad data.

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