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What is Net Present Value: Concept, Usage & Examples

What Is Net Present Value (NPV)?

What Is Positive and Negative NPV?

What Is the NPV Formula?

Pros and Cons of the NPV

Pros

Cons

The time value of money is taken into consideration

Dependent on inputs, estimates and long-term projections

Inclusion of discounted cash flow using the company's capital cost

This does not consider project size

Easy to interpret as it returns a single dollar value

As quantitative inputs drive it, there is no consideration for nonfinancial metrics

Easier to calculate by using calculators and spreadsheets

Difficult to calculate manually

Example of Net Present Value (NPV)

Project 1

In this project, we will take into account a four-year time plan.

Initial investment

$10,000

Discoun trate

10%

Year 1

$5,000

Year 2

$15,000

Year 3

$9,000

Year 4

$18,000

Calculating the present value for each project year.

Year 1

5,000/(1 + .10)^1 = $4,545

Year 2

15,000/(1 + .10)^2 = $12,397

Year 3

9,000/(1 + .10)^3 = $6,762

Year 4

18,000/(1 + .10)^4 = $12,294

Now to find the net present value for this project, we need to find the summation of these values and subtract the initial investment cost.

NPV = ($4,545 + $12,397 + $6,762 + $12,294) - $10,000

Therefore, NPV = $25,998

Project 2

In this project, let us consider a two-year plan.

Initial investment

$5,000

Discount rate

10%

Year 1

$8,000

Year 2

$16,000

Calculating the present value for each project year.

Year 1

8,000/(1 + .10)^1 = $7,273

Year 2

16,000/(1 + .10)^2 = $13,223

So, the resulting formula after calculating the present value for each cash flow and time: 

NPV = ($7,273 + $13,223) - $5,000

Therefore, NPV = $15,496

As we compare the net present value of both these projects, the former is $25,998 while the latter is $15,496. Therefore, according to this result, the company should invest in Project 1 as it has a higher value.

Why Is Net Present Value (NPV) Analysis Used?

Why Are Cash Flows Discounted?

How to Calculate NPV Using Excel?

FAQs About Net Present Value