Net present value (NPV)

Definition

Net present value (NPV) is a financial metric that evaluates the profitability of an investment by calculating the difference between the present value of cash inflows and outflows over time. It considers the time value of money to determine whether a project will yield a positive return.

5 Must Know Facts For Your Next Test

1. NPV accounts for the time value of money, making it a crucial tool in capital budgeting decisions.
2. A positive NPV indicates that the projected earnings exceed the anticipated costs, thus suggesting a profitable investment.
3. The formula for NPV is: NPV = (Cash inflows / (1 + discount rate)^number of periods) - initial investment.
4. Choosing an appropriate discount rate is essential as it reflects the riskiness of the investment and opportunity cost.
5. NPV helps compare multiple projects; the one with the highest NPV is typically preferred.

Review Questions

• What does a positive NPV signify in capital budgeting?
• Why is considering the time value of money important when calculating NPV?
• How does changing the discount rate affect the NPV calculation?

Related terms

Internal Rate of Return (IRR):

The discount rate at which the net present value of an investment equals zero.

Discounted Cash Flow (DCF): A valuation method using future cash flow projections adjusted to their present value using a discount rate.

Payback Period:

The amount of time required for an investment to generate enough cash flows to recoup its initial cost.