Net Present Value (NPV): How to Calculate Net Present Value

In the world of capital budgeting, net present value (NPV) represents the sum value of expected cash flows over a period of time. An investment’s net present value can be positive, negative, or neutral (also called zero NPV).

• Positive NPV: Positive net present value occurs when the difference between the present value of cash inflows is greater than the present value of the cash outflows. This signals a good investment opportunity because you're potentially paying less than what it's worth. A higher NPV is better than a lower NPV.
• Zero NPV: Zero net present value occurs when the present value of cash inflow is equal to the present value of cash outflow. This signals an acceptable investment because you'll potentially be paying exactly what it's worth.
• Negative NPV: Negative net present value occurs when the present value of cash inflow is less than the present value of cash outflow. This signals a poor investment because you’ll potentially be paying more than what it's worth.

Note that you can adjust the time period when calculating the value of future cash flows. The net present value of an investment will depend on the period of time (or number of periods) that you are analyzing. If you take out a loan to make your investment, you will be interested in getting a positive net present value over the course of the payback period. If you won't be borrowing money to invest, you're more interested in the NPV for the number of years you expect to hold the investment.

Investors value net present value calculations for the following reasons.

• NPV can help predict the future return on investment. The greatest significance of NPV is that it provides an estimated snapshot of an investment's long-term value. Investors seek out companies and partnerships with a positive NPV, where the present value of cash inflows is greater than the present value of the cash outflows. A positive NPV signals an excellent investment opportunity—provided that the net cash flow continues in the same direction.
• Finding the net present value of cash flows can help guide investment decisions. Investments come at an opportunity cost. Whenever you make a cash outlay to make an investment, you lose the opportunity to park that money in alternative investments. Thus, an investor might compare two projects—call them Project A and Project B—and try to calculate which has the higher NPV.
• NPV respects the time value of money. The time value of money is based on the premise that the present value of the cash you have is greater than the value of that same amount of cash in the future because you can put present cash to use in money-generating investments. Under this premise, money that gets paid out in the future is not worth as much as money you can have right now. An investor will want a notably positive NPV to make the prospect of future money more lucrative than having money in the present moment.

The NPV formula calculates projected cash flows over the life of the investment, going all the way to the investment's final salvage value (if it has one). From that sum, the formula subtracts the cost of your initial investment.

NPV = P / (1 + i)^t – C

• P = Net period cash flow
• i = Discount rate or required rate of return
• t = Number of time periods
• C = Initial investment

Financial calculators feature an NPV function so you shouldn't need to calculate NPV by hand, but it's still helpful to have a basic understanding of how the net present value formula works.

Start with the NPV formula: NPV = P / (1 + i)^t – C

Follow these steps to calculate NPV.

1. 1. Plug in your initial investment for "C." Your initial investment is typically a single initial cost of the purchase or investment.
2. 2. Figure out your period of time for "t." You must choose a time period in which you'd like to determine if your investment will pay for itself. The time period is usually measured in years. For example, if the goal is for the investment to pay for itself by the end of its third year, then you'd enter "3" for your time period.
3. 3. Determine your net period cash flow for "P." Your cash inflow represents how much money your investment will return throughout the period of time. This is either an estimate calculated by expert data analysts or might be a known value. You'll have separate "P" numbers for each individual unit of time. For example, if your period of time is 3 years then you'll have a "P" value for the first year, second year, and third year.
4. 4. Determine your discount rate for "i." The discount rate is based on the concept that the same amount of money is worth more in the present than in the future. This is because money in your pocket today can be invested in the stock market or held in interest-earning bank accounts, thus increasing its value. Your discount rate is a decimal number that represents the interest rate of a bank account or stock investment with a similar risk level to the expenditure you're evaluating. Alternatively, larger corporations often use their weighted-average cost of capital as their discount rate.
5. 5. Calculate your discounted cash flows using "P / (1 + i)^t." Now that you have all the values for the "P / (1 + i)^t" section of the NPV formula, plug in your numbers. Remember, since you have different "P" values for each year, you must calculate this part of the formula once for each "P" value. So if your time period is 3 years, you'll first enter year one's "P" value, then year two's value, then year three's value. In the end, you'll have 3 separate discounted cash flows for each year.
6. 6. Add up all your discounted cash flows and subtract your initial investment "C." To calculate the total NPV of your expenditure, calculate the sum of all your discounted cash flows and subtract your initial investment "C."

When a company or individual uses the net present value metric to assess a potential investment, they grant themselves two key advantages.

1. 1. NPV calculations necessitate long-term strategic thinking. Calculating a company's NPV requires digging into its financials, understanding its revenue streams, and making an educated guess about its long-term profitability. If you take the time to assess an NPV before investing, you prevent yourself from rushing into an impulsive decision.
2. 2. NPV considers the time value of money. The time value of money (TVM) is the theory that a specific amount of money is worth more when you receive it right away rather than in the future. When you invest money, you incur an opportunity cost because your invested money is no longer available for alternative investments. NPV intrinsically considers this mantra of investing, and it steers companies, individuals, and investment funds toward the most prudent use of their present-day money.

Net present value can be useful in predicting the value of investments, but it does come with two clear drawbacks as a financial planning tool.

1. 1. NPV inherently relies on making predictions. Investors who use the net present value metric take a company's current financial status and project it into the future. Because of this, NPV intrinsically relies on assumptions about how a business will perform in the future. Sometimes these predictions are accurate; other times, they can miss the mark.
2. 2. For some investments, calculating the internal rate of return may be more useful. The internal rate of return, or IRR, is an estimate of the periodic payments you will receive from an investment, whether those come as dividends, profit sharing, stock buybacks, or other financial events that benefit the investor.

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