Net present value

Net present value (NPV) is a financial metric that calculates the difference between the present value of cash inflows and outflows over a project's life, discounted at an appropriate rate to reflect the time value of money and risk (Brealey R.A., Myers S.C. 2020, p.112)^[1]. A project costs $1 million today and generates $300,000 annually for five years. Is it worth doing? NPV answers by converting those future dollars into today's equivalent, then subtracting the initial cost. If the result is positive, the project creates value; if negative, it destroys value.

NPV has been called the gold standard of capital budgeting techniques. Surveys consistently show that 75% or more of large corporations use NPV as their primary investment evaluation method. The technique directly measures value creation in dollar terms, accounts for the timing of cash flows, and provides clear accept/reject criteria. Its theoretical foundation in financial economics makes it the preferred approach among finance professionals.

Calculation

NPV computation involves straightforward mathematics:

Formula

Discounted cash flows. NPV = Σ[CFₜ / (1+r)ᵗ] - Initial Investment, where CFₜ is the cash flow in period t, r is the discount rate, and the sum runs over all periods^[2].

Step by step.

1. Estimate cash flows for each period
2. Select an appropriate discount rate
3. Calculate the present value of each cash flow
4. Sum the present values
5. Subtract the initial investment

Example

Investment: $100,000 Annual cash flows: $30,000 for 5 years Discount rate: 10%

Present values: $27,273 + $24,793 + $22,539 + $20,490 + $18,628 = $113,723 NPV = $113,723 - $100,000 = $13,723

The positive NPV indicates the project creates value^[3].

Discount rate

The rate selection critically affects results:

Cost of capital

Required return. The discount rate typically reflects the company's cost of capital—what it pays for debt and equity financing.

Weighted average. The weighted average cost of capital (WACC) combines the costs of different funding sources in proportion to their use^[4].

Risk adjustment

Project-specific risk. Riskier projects deserve higher discount rates. A speculative new product launch might require a higher rate than expanding a proven facility.

Market comparables. Discount rates can be estimated from similar investments in the market.

Decision rule

NPV provides clear guidance:

Accept if positive. Positive NPV means the project returns more than the required rate—it creates value.

Reject if negative. Negative NPV means the project destroys value—returns are insufficient to justify the risk and capital employed^[5].

Zero is breakeven. An NPV of exactly zero means the project earns exactly the required return—acceptable but not exciting.

Advantages

NPV offers significant benefits:

Dollar value. NPV expresses value creation in absolute terms. A $5 million NPV means $5 million of value created.

Additivity. NPVs can be summed. If projects A and B have NPVs of $3 million and $2 million, doing both creates $5 million in value.

Time value. NPV explicitly accounts for the timing of cash flows—earlier is better^[6].

Completeness. Unlike payback, NPV considers all cash flows over the entire project life.

Limitations

NPV has weaknesses:

Estimation difficulty. Future cash flows are uncertain. NPV assumes we can accurately forecast revenues and costs years into the future.

Discount rate sensitivity. Results depend heavily on the chosen rate. Small changes in discount rate can flip the NPV from positive to negative.

Ignores flexibility. Traditional NPV doesn't capture the value of managerial options—to expand, contract, or abandon projects^[7].

Scale blindness. NPV doesn't indicate return rates. A $1 million NPV on a $10 million investment is more impressive than on a $100 million investment.

Comparison with other methods

NPV relates to alternative techniques:

Internal rate of return

Breakeven rate. IRR is the discount rate that makes NPV equal zero. Projects with IRR exceeding the cost of capital are acceptable.

Ranking issues. IRR can give different rankings than NPV when comparing mutually exclusive projects of different sizes or timing.

Payback period

Simplicity. Payback measures how quickly the initial investment is recovered. Simple but ignores cash flows after payback and time value^[8].

Profitability index

Relative measure. PI equals NPV divided by initial investment, useful when capital is constrained and projects must be compared per dollar invested.

Net present value — recommended articles

Capital budgeting — Internal rate of return — Cost of capital — Investment analysis

References

• Brealey R.A., Myers S.C. (2020), Principles of Corporate Finance, 13th Edition, McGraw-Hill.
• Ross S.A., Westerfield R.W., Jordan B.D. (2019), Fundamentals of Corporate Finance, 12th Edition, McGraw-Hill.
• Damodaran A. (2012), Investment Valuation, 3rd Edition, Wiley.
• CFA Institute (2023), Corporate Finance and Portfolio Management.

Footnotes

1. ↑ Brealey R.A., Myers S.C. (2020), Principles of Corporate Finance, p.112
2. ↑ Ross S.A. et al. (2019), Fundamentals of Corporate Finance, pp.245-262
3. ↑ Damodaran A. (2012), Investment Valuation, pp.89-104
4. ↑ CFA Institute (2023), Corporate Finance
5. ↑ Brealey R.A., Myers S.C. (2020), Principles of Corporate Finance, pp.134-148
6. ↑ Ross S.A. et al. (2019), Fundamentals of Corporate Finance, pp.278-292
7. ↑ Damodaran A. (2012), Investment Valuation, pp.156-172
8. ↑ CFA Institute (2023), Capital Budgeting Methods

Author: Sławomir Wawak