Net present value (NPV)

Definition

Net Present Value (NPV) measures the profitability of an investment by calculating the difference between the present value of cash inflows and outflows over a period. It is used to assess the attractiveness of a project or investment.

5 Must Know Facts For Your Next Test

1. A positive NPV indicates that the projected earnings exceed the anticipated costs, making it a good investment.
2. NPV accounts for the time value of money, which means future cash flows are discounted back to their present value.
3. The discount rate used in NPV calculations often reflects the cost of capital or required rate of return.
4. NPV can be affected by changes in cash flow estimates, discount rates, and project duration.
5. Comparing NPVs allows companies to rank multiple projects and choose those with higher returns.

Review Questions

• What does a positive NPV indicate about an investment?
• Why is the time value of money important in NPV calculations?
• How does changing the discount rate affect the NPV?

Related terms

Internal Rate of Return (IRR):

The discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

Discount Rate:

The interest rate used to discount future cash flows of a financial instrument; determines its present value.

Cash Flow:

The net amount of cash being transferred into and out of a business, especially as it affects liquidity.