Net Present Value

From Wikicpa

The Net Present Value (NPV) of an investment (project) is the difference between the sum of the discounted cash flows which are expected from the investment and the amount which is initially invested. It is a traditional valuation method (often for a project) used in the Discounted Cash Flow measurement methodology, whereby the following steps are undertaken:

1. calculation of expected free cash flows (often per per year) that result out of the investment

2. subtract /discount for the cost of capital (an interest rate to adjust for time and risk)

The intermediate result is called: Present Value.

3. subtract the initial investments

The end result is called: NPV.

So NPV is an amount that expresses how much value an investment will result in. This is done by measuring all cash flows over time back towards the current point in present time.

If the NPV method results in a positive amount, the project should be undertaken.

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

Disadvantage

Although NPV measurement is widely used for making investment decisions, a disadvantage of NPV is that it does not account for flexibility / uncertainty after the project decision.