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NPV Net Present Value

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Definition:

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.

Also Known As: Net Present Value, Discounted Cash Flow, DCF
Examples:

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
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