Net present value
In finance, the net present value (NPV) or net present worth (NPW)[1] applies to a series of cash
flows occurring at different times. The present value of a cash flow depends on the interval of time
between now and the cash flow. It also depends on the discount rate. NPV accounts for the time
value of money. It provides a method for evaluating and comparing capital projects or financial
products with cash flows spread over time, as in loans, investments, payouts from insurance
contracts plus many other applications.
Time value of money dictates that time affects the value of cash flows. For example, a lender may
offer 99 cents for the promise of receiving $1.00 a month from now, but the promise to receive that
same dollar 20 years in the future would be worth much less today to that same person (lender),
even if the payback in both cases was equally certain. This decrease in the current value of future
cash flows is based on a chosen rate of return (or discount rate). If for example there exists a time
series of identical cash flows, the cash flow in the present is the most valuable, with each future cash
flow becoming less valuable than the previous cash flow. A cash flow today is more valuable than an
identical cash flow in the future[2] because a present flow can be invested immediately and begin
earning returns, while a future flow cannot.
NPV is determined by calculating the costs (negative cash flows) and benefits (positive cash flows)
for each period of an investment. The period is typically one year, but could be measured in quarter-
years, half-years or months. After the cash flow for each period is calculated, the present value (PV)
of each one is achieved by discounting its future value (see Formula) at a periodic rate of return (the
rate of return dictated by the market). NPV is the sum of all the discounted future cash flows.
Because of its simplicity, NPV is a useful tool to determine whether a project or investment will result
in a net profit or a loss. A positive NPV results in profit, while a negative NPV results in a loss. The
NPV measures the excess or shortfall of cash flows, in present value terms, above the cost of
funds.[3] In a theoretical situation of unlimited capital budgeting a company should pursue every
investment with a positive NPV. However, in practical terms a company's capital constraints limit
investments to projects with the highest NPV whose cost cash flows, or initial cash investment, do
not exceed the company's capital. NPV is a central tool in discounted cash flow (DCF) analysis and
is a standard method for using the time value of money to appraise long-term projects. It is widely
used throughout economics, finance, and accounting.
In the case when all future cash flows are positive, or incoming (such as the principal and coupon
payment of a bond) the only outflow of cash is the purchase price, the NPV is simply the PV of future
cash flows minus the purchase price (which is its own PV). NPV can be described as the "difference
amount" between the sums of discounted cash inflows and cash outflows. It compares the present
value of money today to the present value of money in the future, taking inflation and returns into
account.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount
curve and outputs a present value, which is the current fair price. The converse process in
discounted cash flow (DCF) analysis takes a sequence of cash flows and a price as input and as
output the discount rate, or internal rate of return (IRR) which would yield the given price as NPV.
This rate, called the yield, is widely used in bond trading.