Net Present Value
Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment or project. It is calculated by subtracting the present value of cash outflows from the present value of cash inflows over a specified period. The formula for NPV is:
NPV = Σ (Cash inflow / (1 + r)^t) – Initial Investment
Where:
- Cash inflow: The Money expected to be received in future periods.
- r: The Discount Rate, reflecting the investment’s risk or Opportunity Cost.
- t: The time period (year) for which the Cash Flow is expected.
NPV helps investors determine whether a project is worth pursuing, with a positive NPV indicating that the projected earnings exceed the anticipated costs, thereby generating profit.
Example:
- An investment requires an initial outlay of $10,000 and is expected to generate cash inflows of $3,000, $4,000, and $5,000 over the next three years. If the Discount Rate is 10%, the NPV calculation would be:
- NPV = ($3,000 / (1 + 0.10)^1) + ($4,000 / (1 + 0.10)^2) + ($5,000 / (1 + 0.10)^3) – $10,000
- Calculating each term results in an NPV of approximately $1,228. Thus, the investment is considered worthwhile.
Case:
- A company is evaluating a new product line. They expect to invest $50,000 upfront and receive $20,000 annually for the next three years. If the Discount Rate is 8%, the NPV calculation will help the company decide whether to proceed with the project based on whether the NPV is positive or negative.