net present value
cash inflows minus cash outflows the value of an investment calculated as the sum of its initial cost and the present value of expected future cash flows
A positive NPV indicates that the project should be profitable, assuming that the estimated cash flows are reasonably accurate. A negative NPV indicates that the project will probably be unprofitable and therefore should be adjusted, if not abandoned altogether.
NPV enables management to consider the time-value of money it will invest. This concept holds that the value of money increases with time because it can always earn interest in a savings account. When the time-value-of-money concept is incorporated in the calculation of NPV, the value of a project's future net cash receipts in "today's money" can be determined. This enables proper comparisons between different projects.
For example, if Global Manufacturing Inc. is considering the acquisition of a new machine, its management will consider all the factors: initial purchase and installation costs; additional revenues generated by sales of the new machine's products, plus the taxes on these new revenues. Having accounted for these factors in its calculations, the cash flows that Global Manufacturing projects will generate from the new machine are:
|Year 1||−100,000 (initial cost of investment)|
At first glance, it appears that cash flows total 45% more than the $100,000 initial cost, a sound investment indeed. But the time-value of money shrinks the return on the project considerably, since future dollars are worth less than present dollars in hand. NPV accounts for these differences with the help of present-value tables, which list the ratios that express the present value of expected cash flow dollars, based on the applicable interest rate and the number of years in question.
In the example, Global Manufacturing's cost of capital is 9%. Using this figure to find the corresponding ratios on the present value table, the $100,000 investment cost and expected annual revenues during the five years in question, the NPV calculation looks like this:
|Year||Cash flow||Table factor (at 9%)||Present value|
|1||($100,000) ×||1.000000 =||($100,000)|
|2||$30,000 ×||0.917431 =||$27,522.93|
|3||$40,000 ×||0.841680 =||$33,667.20|
|4||$40,000 ×||0.772183 =||$30,887.32|
|5||$35,000 ×||0.708425 =||$24,794.88|
NPV is still positive. So, on this basis at least, the investment should proceed.
Related definitions of "net present value"
- Abbr NPV