NPV is an abbreviation for Net Present Value, also known as Discounted Cash Flow or DCF.
Calculating NPV is a method for evaluating projects or investments, and is utilized in capital budgeting. It is an application of a fundamental concept in economics and finance called the Time Value of Money, which, in turn, utilizes the arithmetic of compound interest in reverse. A dollar received in the future is less valuable than a dollar received today.
The steps involved in calculating NPV are:
- Determine all cash flows associated with a project or investment and their timing (e.g., the years in which they will occur).
- These cash flows can be both negative (when money is spent) and positive (when money is received).
- Determine an appropriate interest rate, also known as a discount rate, to bring each future cash flow to its equivalent present value (PV).
- Add the PVs of all cash flows, both positive and negative.
A special application of NPV is the computation of IRR, or Internal Rate of Return, also known as a Hurdle Rate.
In a simple case, where:
- You make an investment of $1,000 in year 1
- The discount rate is 10%
- You expect to receive $110 in year 2
- You expect to receive $1,200 in year 3
The NPV of the investment would be:
- The year 1 cash flow is -$1,000
- The PV of the year 2 cash flow = $110/1.10 = $100
- The PV of the year 3 cash flow = $1,200/(1.10^2) = $1,200/1.21 = $991.74
- The NPV thus = -$1,000 + $100 + $991.74 = $91.74