What is NPV?
Net Present Value (NPV) is a financial metric that helps investors evaluate the profitability of an investment by calculating the present value of all expected cash flows associated with the project.
How is NPV calculated?
NPV is calculated by subtracting the initial investment from the sum of the present values of all cash inflows and outflows over the project’s lifespan. The formula is:
NPV = (Cash Flow / (1 + r)^t) – Initial Investment
Why is NPV important?
NPV is vital for making investment decisions as it considers the time value of money and helps investors determine whether an investment will yield a positive return.
Example:
Let’s say you are considering investing $10,000 in a project that will generate cash inflows of $3,000 per year for the next 5 years. If your required rate of return is 5%, the NPV of the project would be calculated as follows:
- Year 1: $3,000 / (1 + 0.05)^1 = $2,857.14
- Year 2: $3,000 / (1 + 0.05)^2 = $2,722.22
- …
- Year 5: $3,000 / (1 + 0.05)^5 = $2,432.90
Summing up all the present values and subtracting the initial investment of $10,000 would give you the NPV of the project.
Case Study:
Company XYZ is evaluating two investment projects. Project A has an NPV of $50,000, while Project B has an NPV of $30,000. Based on NPV alone, Project A would be the better investment as it offers a higher return.
Statistics:
A study conducted by Harvard Business Review found that 70% of companies use NPV as a primary tool for capital budgeting decisions.
