| net present value The discounted value of an investment's cash inflows minus the discounted value of its cash outflows. To be adequately profitable, an investment should have a net present value greater than zero. For investment in securities, the initial cost is usually the only outflow. |
An analytical tool for evaluating whether or not to purchase an investment. The tool does not tell you if an investment is good or bad;it tells you if the investment will meet your predetermined objectives or not.
• Critical to defining your objectives is setting the equivalent of an interest rate you would like to earn on your initial cash investment. This is called the discount rate. The discount rate may change from investment to investment, depending on your assessment of the risk. The safest investment is an FDIC-insured savings account, but it returns the lowest interest rate. You, the investor, decide what rate you would like to earn. You use the net-present-value tool to calculate whether a particular investment will earn the rate you want.
• Having said all that, the official definition of net present value is as follows: using a preselected discount rate, net present value is the present value of all cash incomes, less the present value of all cash outflows (including initial investment). If this is not clear, it will become so with the example below.
• If the net present value is 0 or a positive number, the investor should go forward. If the answer is negative for the discount rate selected, then the investment should not be made because it will not meet the investor's objectives, not because it is a “bad investment” in the ordinary sense of that phrase.
• The Excel formula for present value is pv (rate, cashflow, cashflow, cashflow)
‘'Rate” is the cell with the interest rate the investor would like to earn. Each of the “cashflow” entries is a cell address for cash flows by the end of each year, such as year 1, year 2, year 3, and so on. If an asset is sold in a particular year, the net sales price (after expenses of the sale) is entered as part of the cash flow for that year. One flaw of the system is that it assumes all cash flows are received at year-end, when they are really received over time, but that is usually a relatively minor problem.
What Does Net Present Value (NPV) Mean?
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project may yield. It is calculated as shown here:
Investopedia explains Net Present Value (NPV)
NPV compares the value of a dollar today to the value of that dollar at a future point, taking inflation and returns into account. If the NPV of a prospective project is positive, the project should be accepted. However, if NPV is negative, the project probably should be rejected because cash flows will be negative. For example, if a retail clothing business wants to purchase an existing store, it will estimate the future cash flows of the store and then discount those cash flows into one lump-sum present value amount, say, $565,000. If the owner of the store is willing to sell the business for less than $565,000, the purchasing company probably will accept the offer because it is a positive NPV investment. Conversely, if the owner will not sell for less than $565,000, the purchaser will not buy the store, as the investment presents a negative NPV and therefore will reduce the overall value of the clothing company.
Related Terms:
• Discounted Cash Flow—DCF
• Discount Rate
• Payback Period
• Present Value—PV
• Time Value of Money
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