Your business is considering a $100,000 machine that will bring in $30,000 a year for five years. Good deal? The answer depends on the net present value (NPV) โ the sum of every future cash flow discounted back to today.
What Is NPV?
Net Present Value is the total value of an investment measured in today's money. It is the most reliable single metric in corporate finance for deciding whether to accept or reject a project.
NPV = โInitial Investment + ฮฃ (Cash Flow Year t รท (1 + r)^t)
The Golden Rule
| NPV | Decision |
|---|---|
| Positive | โ Accept โ the project adds value |
| Zero | Indifferent โ breaks even in today's money |
| Negative | โ Reject โ it destroys value |
Worked Example
Investment: $100,000. Cash flows: $25,000, $30,000, $35,000, $40,000 over 4 years. Discount rate: 10%.
| Year | Cash Flow | Discount Factor | PV of Cash Flow |
|---|---|---|---|
| 0 | โ$100,000 | 1.000 | โ$100,000 |
| 1 | $25,000 | 1/1.1 = 0.909 | $22,727 |
| 2 | $30,000 | 1/1.21 = 0.826 | $24,793 |
| 3 | $35,000 | 1/1.331 = 0.751 | $26,296 |
| 4 | $40,000 | 1/1.464 = 0.683 | $27,321 |
NPV = โ100,000 + 22,727 + 24,793 + 26,296 + 27,321 = +$1,137
The NPV is positive, so the project adds about $1,137 of value at a 10% required return. Accept it.
Two Bonus Metrics Your NPV Implies
Profitability Index (PI) = PV of cash flows รท initial investment. Above 1 means the project creates value per dollar invested.
Payback Period โ how long until the cumulative cash flows recover the initial outlay. In our example, the $100,000 is recovered partway through year 4.
Common Pitfalls
- Forgetting working capital changes at the start and end of a project
- Using a discount rate that ignores risk โ riskier projects need higher rates
- Comparing NPVs of projects with different lifespans โ normalize first
๐ก Pro Tip: Always use incremental cash flows โ only the cash the project adds versus doing nothing. Sunk costs never count.
Try Our Tools
- NPV Calculator โ flows in, verdict out
- Present Value Calculator โ discount single amounts
- ROI Calculator โ the quick and dirty check
*Run the numbers on your next investment with our free NPV Calculator.*
