Net Present Value (NPV)

The value of all future cash flows over an investment's entire life discounted to the present

What is Net Present Value (NPV)?

Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of a
business, investment security, capital project, new venture, cost reduction program, and
anything that involves cash flow.

NPV Formula

The formula for Net Present Value is:

Where:

• Z1 = Cash flow in time 1

• Z2 = Cash flow in time 2
• r = Discount rate
• X0 = Cash outflow in time 0 (i.e. the purchase price / initial
investment)

Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth. It is an all-encompassing metric, as it takes into account all revenues, expenses,
and capital costs associated with an investment in its Free Cash Flow (FCF).

In addition to factoring all revenues and costs, it also takes into account the timing of each cash
flow that can result in a large impact on the present value of an investment. For example, it’s
better to see cash inflows sooner and cash outflows later, compared to the opposite.

Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust
for the risk of an investment opportunity, and (2) to account for the time value of money
(TVM).

The first point (to adjust for risk) is necessary because not all businesses, projects, or
investment opportunities have the same level of risk. Put another way, the probability of
receiving cash flow from a US Treasury bill is much higher than the probability of receiving
cash flow from a young technology startup.

To account for the risk, the discount rate is higher for riskier investments and lower for a safer
one. The US treasury example is considered to be the risk-free rate, and all other investments
are measured by how much more risk they bear relative to that.

The second point (to account for the time value of money) is required because due to inflation,
interest rates, and opportunity costs, money is more valuable the sooner it’s received. For
example, receiving $1 million today is much better than the $1 million received five years from
now. If the money is received today, it can be invested and earn interest, so it will be worth
more than $1 million in five years’ time.

Example of Net Present Value (NPV)

Let’s look at an example of how to calculate the net present value of a series of cash flows. As
you can see in the screenshot below, the assumption is that an investment will return $10,000
per year over a period of 10 years, and the discount rate required is 10%.

The final result is that the value of this investment is worth $61,446 today. It means a rational
investor would be willing to pay up to $61,466 today to receive $10,000 every year over 10
years. By paying this price, the investor would receive an internal rate of return (IRR) of 10%.
By paying anything less than $61,000, the investor would earn an internal rate of return that’s
greater than 10%.

Internal Rate of Return (IRR) and NPV

The internal rate of return (IRR) is the discount rate at which the net present value of an
investment is equal to zero. Put another way, it is the compound annual return an investor
expects to earn (or actually earned) over the life of an investment.

For example, if a security offers a series of cash flows with an NPV of $50,000 and an investor
pays exactly $50,000 for it, then the investor’s NPV is $0. It means they will earn whatever the
discount rate is on the security. Ideally, an investor would pay less than $50,000 and therefore
earn an IRR that’s greater than the discount rate.

Typically, investors and managers of businesses look at both NPV and IRR in conjunction with
other figures when making a decision. Learn about IRR vs. XIRR in Excel.

Negative vs. Positive Net Present Value

If the net present value of a project or investment, is negative it means the expected rate of
return that will be earned on it is less than the discount rate (required rate of return or hurdle
rate). This doesn’t necessarily mean the project will “lose money.” It may very well generate
accounting profit (net income), but since the rate of return generated is less than the discount
rate, it is considered to destroy value. If the NPV is positive, it creates value.

NPV of a Business

To value a business, an analyst will build a detailed discounted cash flow DCF model in Excel.
This financial model will include all revenues, expenses, capital costs, and details of the
business.

Once the key assumptions are in place, the analyst can build a five-year forecast of the three
financial statements (income statement, balance sheet, and cash flow) and calculate the free
cash flow of the firm (FCFF), also known as the unlevered free cash flow.

Finally, a terminal value is used to value the company beyond the forecast period, and all cash
flows are discounted back to the present at the firm’s weighted average cost of capital. To learn
more, check out CFI’s free detailed financial modeling course.

NPV of a Project

To value a project is typically more straightforward than an entire business. A similar approach
is taken, where all the details of the project are modeled into Excel, however, the forecast period
will be for the life of the project, and there will be no terminal value. Once the free cash flow
is calculated, it can be discounted back to the present at either the firm’s WACC or the
appropriate hurdle rate.
Drawbacks of Net Present Value

While net present value (NPV) is the most commonly used method for evaluating investment
opportunities, it does have some drawbacks that should be carefully considered.

Key challenges to NPV analysis include:

• A long list of assumptions has to be made

• Sensitive to small changes in assumptions and drivers
• Easily manipulated to produce the desired output
• May not capture second- and third-order benefits/impacts
(i.e., on other parts of a business)
• Assumes a constant discount rate over time
• Accurate risk adjustment is challenging to perform (hard to
get data on correlations, probabilities)