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What is Net Present Value (NPV)?

Net present value (NPV) is the sum of an investment's future cash flows discounted back to today's value, minus the initial cost. Because money today is worth more than money later, each future amount is reduced by a discount rate. A positive NPV means the investment is expected to create value.

NPV rests on one idea: a euro received today is worth more than a euro received next year, because today's euro can be invested and earn a return. Discounting future cash flows at a chosen rate converts them all to a common, present-day basis, so projects of different sizes and timing can be compared fairly.

The decision rule is simple. If the NPV is positive, the investment is expected to return more than the cost of the money used to fund it, so it adds value. If it is negative, the project returns less than the discount rate and should usually be rejected. The discount rate is the key assumption: a higher rate makes future cash worth less and can flip a positive NPV to negative.

Example

A project costs €10,000 today and is expected to return €4,000 a year for three years. Discounted at a rate that reflects the cost of capital, the future returns have a present value of €11,200, so the NPV is €1,200 and the project is worth doing.

Questions

What does a positive NPV mean?

It means the investment's future cash flows, discounted to today, exceed its cost, so the project is expected to create value above the required return. A negative NPV means the project returns less than the cost of capital and should usually be declined.

How is the discount rate chosen for NPV?

It usually reflects the cost of capital or the return the business could earn on an alternative investment of similar risk. A higher discount rate lowers the present value of future cash, so the choice of rate materially affects the result.

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