Net present value

The net present value (NPV) or net present worth (NPW)[1] is a way of measuring the value of an
asset that has cashflow by adding up the present value of all the future cash flows that asset will generate.
The present value of a cash flow depends on the interval of time between now and the cash flow because
of the Time value of money (which includes the annual effective discount rate). 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. 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, financial
analysis, and financial 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.
Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then all are summed such that
NPV is the sum of all terms:

where:

t is the time of the cash flow

i is the discount rate, i.e. the return that could be earned per unit of time on an investment
with similar risk
is the net cash flow i.e. cash inflow − cash outflow, at time t. For educational purposes,
is commonly placed to the left of the sum to emphasize its role as (minus) the
investment.
is the discount factor, also known as the present value factor.
The result of this formula is multiplied with the Annual Net cash in-flows and reduced by Initial Cash
outlay the present value, but in cases where the cash flows are not equal in amount, the previous formula
will be used to determine the present value of each cash flow separately. Any cash flow within 12 months
will not be discounted for NPV purpose, nevertheless the usual initial investments during the first year R0
are summed up a negative cash flow.[4]

The NPV can also be thought of as the difference between the discounted benefits and costs over time. As
such, the NPV can also be written as:

where:

B are the benefits or cash inflows

C are the costs or cash outflows
Given the (period, cash inflows, cash outflows) shown by (t, , ) where N is the total number of
periods, the net present value is given by:

where:

are the benefits or cash inflows at time t.

are the costs or cash outflows at time t.
The NPV can be rewritten using the net cash flow in each time period as:

By convention, the initial period occurs at time , where cash flows in successive periods are then
discounted from and so on. Furthermore, all future cash flows during a period are assumed
to be at the end of each period.[5] For constant cash flow R, the net present value is a finite
geometric series and is given by:

Inclusion of the term is important in the above formulae. A typical capital project involves a large
negative cashflow (the initial investment) with positive future cashflows (the return on the
investment). A key assessment is whether, for a given discount rate, the NPV is positive (profitable) or
negative (loss-making). The IRR is the discount rate for which the NPV is exactly 0.

Capital efficiency
The NPV method can be slightly adjusted to calculate how much money is contributed to a project's
investment per dollar invested. This is known as the capital efficiency ratio. The formula for the net
present value per dollar investment (NPVI) is given below:

where:

is the net cash flow i.e. cash inflow − cash outflow, at time t.
are the net cash outflows, at time t.

Example
If the discounted benefits across the life of a project are $100 million and the discounted net costs across
the life of a project are $60 million then the NPVI is:

$100M-$60M
NPVI= ⁠ $60M ⁠≈ 0.6667

That is for every dollar invested in the project, a contribution of $0.6667 is made to the project's NPV.[6]
Alternative discounting frequencies
The NPV formula assumes that the benefits and costs occur at the end of each period, resulting in a more
conservative NPV. However, it may be that the cash inflows and outflows occur at the beginning of the
period or in the middle of the period.

The NPV formula for mid period discounting is given by:

Over a project's lifecycle, cash flows are typically spread across each period (for example spread across
each year), and as such the middle of the year represents the average point in time in which these cash
flows occur. Hence mid period discounting typically provides a more accurate, although less conservative
NPV.[7][8] ЧикЙ The NPV formula using beginning of period discounting is given by:

This results in the least conservative NPV.

The discount rate

The rate used to discount future cash flows to the present value is a key variable of this process.

A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is
appropriate to use higher discount rates to adjust for risk, opportunity cost, or other factors. A variable
discount rate with higher rates applied to cash flows occurring further along the time span might be used
to reflect the yield curve premium for long-term debt.

Another approach to choosing the discount rate factor is to decide the rate which the capital needed for
the project could return if invested in an alternative venture. If, for example, the capital required for
Project A can earn 5% elsewhere, use this discount rate in the NPV calculation to allow a direct
comparison to be made between Project A and the alternative. Related to this concept is to use the firm's
reinvestment rate. Re-investment rate can be defined as the rate of return for the firm's investments on
average. When analyzing projects in a capital constrained environment, it may be appropriate to use the
reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects
opportunity cost of investment, rather than the possibly lower cost of capital.

An NPV calculated using variable discount rates (if they are known for the duration of the investment)
may better reflect the situation than one calculated from a constant discount rate for the entire investment
duration. Refer to the tutorial article written by Samuel Baker[9] for more detailed relationship between
the NPV and the discount rate.
For some professional investors, their investment funds are committed to target a specified rate of return.
In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this
way, a direct comparison can be made between the profitability of the project and the desired rate of
return.

To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the
intent is simply to determine whether a project will add value to the company, using the firm's weighted
average cost of capital may be appropriate. If trying to decide between alternative investments in order to
maximize the value of the firm, the corporate reinvestment rate would probably be a better choice.

Risk-adjusted net present value (rNPV)

Using variable rates over time, or discounting "guaranteed" cash flows differently from "at risk" cash
flows, may be a superior methodology but is seldom used in practice. Using the discount rate to adjust for
risk is often difficult to do in practice (especially internationally) and is difficult to do well.

An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk
elements using risk-adjusted net present value (rNPV) or a similar method, then discount at the firm's
rate.

Use in decision making

NPV is an indicator of how much value an investment or project adds to the firm. With a particular
project, if is a positive value, the project is in the status of positive cash inflow in the time of t. If
is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately
risked projects with a positive NPV could be accepted. This does not necessarily mean that they should
be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e., comparison
with other available investments. In financial theory, if there is a choice between two mutually exclusive
alternatives, the one yielding the higher NPV should be selected. A positive net present value indicates
that the projected earnings generated by a project or investment (in present dollars) exceeds the
anticipated costs (also in present dollars). This concept is the basis for the Net Present Value Rule, which
dictates that the only investments that should be made are those with positive NPVs.

An investment with a positive NPV is profitable, but one with a negative NPV will not necessarily result
in a net loss: it is just that the internal rate of return of the project falls below the required rate of return.

If... It means... Then...

the investment would add value to the

NPV > 0 the project may be accepted
firm

the investment would subtract value

NPV < 0 the project may be rejected
from the firm
We should be indifferent in the decision whether to
accept or reject the project. This project adds no
the investment would neither gain nor
NPV = 0 monetary value. Decision should be based on other
lose value for the firm
criteria, e.g., strategic positioning or other factors not
explicitly included in the calculation.
Advantages and disadvantages of using Net Present Value
NPV is an indicator for project investments, and has several advantages and disadvantages for decision-
making.

Advantages
The NPV includes all relevant time and cash flows for the project by considering the time value of
money, which is consistent with the goal of wealth maximization by creating the highest wealth for
shareholders.

The NPV formula accounts for cash flow timing patterns and size differences for each project, and
provides an easy, unambiguous dollar value comparison of different investment options.[10][11]

The NPV can be easily calculated using modern spreadsheets, under the assumption that the discount rate
and future cash flows are known. For a firm considering investing in multiple projects, the NPV has the
benefit of being additive. That is, the NPVs of different projects may be aggregated to calculate the
highest wealth creation, based on the available capital that can be invested by a firm.[12]

Disadvantages
The NPV method has several disadvantages.

The NPV approach does not consider hidden costs and project size. Thus, investment decisions on
projects with substantial hidden costs may not be accurate.[13]

Relies on input parameters such as knowledge of future cash flows

The NPV is heavily dependent on knowledge of future cash flows, their timing, the length of a project,
the initial investment required, and the discount rate. Hence, it can only be accurate if these input
parameters are correct; although, sensitivity analyzes can be undertaken to examine how the NPV
changes as the input variables are changed, thus reducing the uncertainty of the NPV.[14]

Relies on choice of discount rate and discount factor

The accuracy of the NPV method relies heavily on the choice of a discount rate and hence discount
factor, representing an investment's true risk premium.[15] The discount rate is assumed to be constant
over the life of an investment; however, discount rates can change over time. For example, discount rates
can change as the cost of capital changes.[16][10] There are other drawbacks to the NPV method, such as
the fact that it displays a lack of consideration for a project’s size and the cost of capital.[17][11]

Lack of consideration of non-financial metrics

The NPV calculation is purely financial and thus does not consider non-financial metrics that may be
relevant to an investment decision.[18]
Difficulty in comparing mutually exclusive projects
Comparing mutually exclusive projects with different investment horizons can be difficult. Since unequal
projects are all assumed to have duplicate investment horizons, the NPV approach can be used to
compare the optimal duration NPV.[19]

Interpretation as integral transform

The time-discrete formula of the net present value

can also be written in a continuous variation

where

r(t) is the rate of flowing cash given in money per time, and r(t) = 0 when the investment is
over.

Net present value can be regarded as Laplace-[20][21] respectively Z-transformed cash flow with the
integral operator including the complex number s which resembles to the interest rate i from the real
number space or more precisely s = ln(1 + i).

From this follow simplifications known from cybernetics, control theory and system dynamics. Imaginary
parts of the complex number s describe the oscillating behaviour (compare with the pork cycle, cobweb
theorem, and phase shift between commodity price and supply offer) whereas real parts are responsible
for representing the effect of compound interest (compare with damping).

Example
A corporation must decide whether to introduce a new product line. The company will have immediate
costs of 100,000 at t = 0. Recall, a cost is a negative for outgoing cash flow, thus this cash flow is
represented as −100,000. The company assumes the product will provide equal benefits of 10,000 for
each of 12 years beginning at t = 1. For simplicity, assume the company will have no outgoing cash
flows after the initial 100,000 cost. This also makes the simplifying assumption that the net cash received
or paid is lumped into a single transaction occurring on the last day of each year. At the end of the 12
years the product no longer provides any cash flow and is discontinued without any additional costs.
Assume that the effective annual discount rate is 10%.

The present value (value at t = 0) can be calculated for each year:

 Year Cash flow Present value

T=0 −100,000

T=1 9,090.91

T=2 8,264.46

T=3 7,513.15

T=4 6,830.13

T=5 6,209.21

T=6 5,644.74

T=7 5,131.58

T=8 4,665.07

T=9 4,240.98

T = 10 3,855.43

T = 11 3,504.94

T = 12 3,186.31

The total present value of the incoming cash flows is 68,136.91. The total present value of the outgoing
cash flows is simply the 100,000 at time t = 0. Thus:

In this example:

Observe that as t increases the present value of each cash flow at t decreases. For example, the final
incoming cash flow has a future value of 10,000 at t = 12 but has a present value (at t = 0) of 3,186.31.
The opposite of discounting is compounding. Taking the example in reverse, it is the equivalent of
investing 3,186.31 at t = 0 (the present value) at an interest rate of 10% compounded for 12 years, which
results in a cash flow of 10,000 at t = 12 (the future value).
The importance of NPV becomes clear in this instance. Although the incoming cash flows
(10,000 × 12 = 120,000) appear to exceed the outgoing cash flow (100,000), the future cash flows are
not adjusted using the discount rate. Thus, the project appears misleadingly profitable. When the cash
flows are discounted however, it indicates the project would result in a net loss of 31,863.09. Thus, the
NPV calculation indicates that this project should be disregarded because investing in this project is the
equivalent of a loss of 31,863.09 at t = 0. The concept of time value of money indicates that cash flows
in different periods of time cannot be accurately compared unless they have been adjusted to reflect their
value at the same period of time (in this instance, t = 0).[2] It is the present value of each future cash flow
that must be determined in order to provide any meaningful comparison between cash flows at different
periods of time. There are a few inherent assumptions in this type of analysis:

1. The investment horizon of all possible investment projects considered are equally
acceptable to the investor (e.g. a 3-year project is not necessarily preferable vs. a 20-year
project.)
2. The 10% discount rate is the appropriate (and stable) rate to discount the expected cash
flows from each project being considered. Each project is assumed equally speculative.
3. The shareholders cannot get above a 10% return on their money if they were to directly
assume an equivalent level of risk. (If the investor could do better elsewhere, no projects
should be undertaken by the firm, and the excess capital should be turned over to the
shareholder through dividends and stock repurchases.)
More realistic problems would also need to consider other factors, generally including: smaller time
buckets, the calculation of taxes (including the cash flow timing), inflation, currency exchange
fluctuations, hedged or unhedged commodity costs, risks of technical obsolescence, potential future
competitive factors, uneven or unpredictable cash flows, and a more realistic salvage value assumption,
as well as many others.

A more simple example of the net present value of incoming cash flow over a set period of time, would
be winning a Powerball lottery of $500 million. If one does not select the "CASH" option they will be
paid $25,000,000 per year for 20 years, a total of $500,000,000, however, if one does select the "CASH"
option, they will receive a one-time lump sum payment of approximately $285 million, the NPV of
$500,000,000 paid over time. See "other factors" above that could affect the payment amount. Both
scenarios are before taxes.

Common pitfalls
If, for example, the Rt are generally negative late in the project (e.g., an industrial or mining
project might have clean-up and restoration costs), then at that stage the company owes
money, so a high discount rate is not cautious but too optimistic. Some people see this as a
problem with NPV. A way to avoid this problem is to include explicit provision for financing
any losses after the initial investment, that is, explicitly calculate the cost of financing such
losses.
Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst
a bank might charge a higher rate of interest for a risky project, that does not mean that this
is a valid approach to adjusting a net present value for risk, although it can be a reasonable
approximation in some specific cases. One reason such an approach may not work well can
be seen from the following: if some risk is incurred resulting in some losses, then a discount
rate in the NPV will reduce the effect of such losses below their true financial cost. A
 rigorous approach to risk requires identifying and valuing risks explicitly, e.g., by actuarial or
Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.
Yet another issue can result from the compounding of the risk premium. R is a composite of
the risk free rate and the risk premium. As a result, future cash flows are discounted by both
the risk-free rate as well as the risk premium and this effect is compounded by each
subsequent cash flow. This compounding results in a much lower NPV than might be
otherwise calculated. The certainty equivalent model can be used to account for the risk
premium without compounding its effect on present value.
Another issue with relying on NPV is that it does not provide an overall picture of the gain or
loss of executing a certain project. To see a percentage gain relative to the investments for
the project, usually, Internal rate of return or other efficiency measures are used as a
complement to NPV.
Non-specialist users frequently make the error of computing NPV based on cash flows after
interest. This is wrong because it double counts the time value of money. Free cash flow
should be used as the basis for NPV computations.
When using Microsoft's Excel, the "=NPV(...)" formula makes two assumptions that result in
an incorrect solution. The first is that the amount of time between each item in the input
array is constant and equidistant (e.g., 30 days of time between item 1 and item 2) which
may not always be correct based on the cash flow that is being discounted. The second item
is that the function will assume the item in the first position of the array is period 1 not period
zero. This then results in incorrectly discounting all array items by one extra period. The
easiest fix to both of these errors is to use the "=XNPV(...)" formula.

Software support
Many computer-based spreadsheet programs have built-in formulae for PV and NPV.

History
Net present value as a valuation methodology dates at least to the 19th century. Karl Marx refers to NPV
as fictitious capital, and the calculation as "capitalising," writing:[22]

The forming of a fictitious capital is called capitalising. Every periodically repeated income is
capitalised by calculating it on the average rate of interest, as an income which would be
realised by a capital at this rate of interest.

In mainstream neo-classical economics, NPV was formalized and popularized by Irving Fisher, in his
1907 The Rate of Interest and became included in textbooks from the 1950s onwards, starting in finance
texts.[23][24]

Alternative capital budgeting methods

Adjusted present value (APV): adjusted present value, is the net present value of a project if
financed solely by ownership equity plus the present value of all the benefits of financing.
Accounting rate of return (ARR): a ratio similar to IRR and MIRR
Cost-benefit analysis: which includes issues other than cash, such as time savings.
 Internal rate of return (IRR): which calculates the rate of return of a project while
disregarding the absolute amount of money to be gained.
Modified internal rate of return (MIRR): similar to IRR, but it makes explicit assumptions
about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return.
Payback period: which measures the time required for the cash inflows to equal the original
outlay. It measures risk, not return.
Real option: which attempts to value managerial flexibility that is assumed away in NPV.
Equivalent annual cost (EAC): a capital budgeting technique that is useful in comparing two
or more projects with different lifespans.

Adjusted present value

Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers.[25] The idea is
to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of
the tax shield of debt – and other side effects.[26]

Accounting rate of return

The accounting rate of return, also known as average rate of return, or ARR, is a financial ratio used in
capital budgeting.[27] The ratio does not take into account the concept of time value of money. ARR
calculates the return, generated from net income of the proposed capital investment. The ARR is a
percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of
each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project
is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the
higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when
appraising projects.[28]

Cost-benefit analysis
Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis, is a systematic approach to
estimating the strengths and weaknesses of alternatives. It is used to determine options which provide the
best approach to achieving benefits while preserving savings in, for example, transactions, activities, and
functional business requirements.[29] A CBA may be used to compare completed or potential courses of
action, and to estimate or evaluate the value against the cost of a decision, project, or policy. It is
commonly used to evaluate business or policy decisions (particularly public policy), commercial
transactions, and project investments. For example, the U.S. Securities and Exchange Commission must
conduct cost–benefit analyses before instituting regulations or deregulations.[30]: 6

1. To determine if an investment (or decision) is sound, ascertaining if – and by how much – its
benefits outweigh its costs.
2. To provide a basis for comparing investments (or decisions), comparing the total expected
cost of each option with its total expected benefits.

Internal rate of return

Internal rate of return (IRR) is a method of calculating an investment's rate of return. The term internal
refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost
of capital, or financial risk.
Modified internal rate of return
The modified internal rate of return (MIRR) is a financial measure of an investment's
attractiveness.[31][32] It is used in capital budgeting to rank alternative investments of unequal size. As the
name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve
some problems with the IRR.

Payback period
Payback period in capital budgeting refers to the time required to recoup the funds expended in an
investment, or to reach the break-even point. [33]

Equivalent annual cost

In finance, the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its
entire lifespan. It is calculated by dividing the negative NPV of a project by the "present value of annuity
factor":

, where

where r is the annual interest rate and

t is the number of years.

Alternatively, EAC can be obtained by multiplying the NPV of the project by the "loan repayment
factor".

EAC is often used as a decision-making tool in capital budgeting when comparing investment projects of
unequal lifespans. However, the projects being compared must have equal risk: otherwise, EAC must not
be used.[34]

The technique was first discussed in 1923 in engineering literature,[35] and, as a consequence, EAC
appears to be a favoured technique employed by engineers, while accountants tend to prefer net present
value (NPV) analysis.[36] Such preference has been described as being a matter of professional education,
as opposed to an assessment of the actual merits of either method.[37] In the latter group, however, the
Society of Management Accountants of Canada endorses EAC, having discussed it as early as 1959 in a
published monograph[38] (which was a year before the first mention of NPV in accounting textbooks).[39]

See also
Profitability index

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3. erk, DeMarzo, and Stangeland, p. 64.
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