It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
Because of its simplicity, NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss.
The NPV measures the excess or shortfall of cash flows, in present value terms, above the cost of funds.
[3] In a theoretical situation of unlimited capital budgeting, a company should pursue every investment with a positive NPV.
NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects.
The converse process in discounted cash flow (DCF) analysis takes a sequence of cash flows and a price as input and as output the discount rate, or internal rate of return (IRR) which would yield the given price as NPV.
A key assessment is whether, for a given discount rate, the NPV is positive (profitable) or negative (loss-making).
The NPV formula for mid period discounting is given by: Over a project's lifecycle, cash flows are typically spread across each period (for example spread across each year), and as such the middle of the year represents the average point in time in which these cash flows occur.
The rate used to discount future cash flows to the present value is a key variable of this process.
Refer to the tutorial article written by Samuel Baker[9] for more detailed relationship between the NPV and the discount rate.
If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate.
If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice.
In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.
This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPVs.
[10][11] The NPV can be easily calculated using modern spreadsheets, under the assumption that the discount rate and future cash flows are known.
That is, the NPVs of different projects may be aggregated to calculate the highest wealth creation, based on the available capital that can be invested by a firm.
[13] The NPV is heavily dependent on knowledge of future cash flows, their timing, the length of a project, the initial investment required, and the discount rate.
[16][10] There are other drawbacks to the NPV method, such as the fact that it displays a lack of consideration for a project’s size and the cost of capital.
[19] The time-discrete formula of the net present value can also be written in a continuous variation where Net present value can be regarded as Laplace-[20][21] respectively Z-transformed cash flow with the integral operator including the complex number s which resembles to the interest rate i from the real number space or more precisely s = ln(1 + i).
Imaginary parts of the complex number s describe the oscillating behaviour (compare with the pork cycle, cobweb theorem, and phase shift between commodity price and supply offer) whereas real parts are responsible for representing the effect of compound interest (compare with damping).
This also makes the simplifying assumption that the net cash received or paid is lumped into a single transaction occurring on the last day of each year.
At the end of the 12 years the product no longer provides any cash flow and is discontinued without any additional costs.
Taking the example in reverse, it is the equivalent of investing 3,186.31 at t = 0 (the present value) at an interest rate of 10% compounded for 12 years, which results in a cash flow of 10,000 at t = 12 (the future value).
There are a few inherent assumptions in this type of analysis: More realistic problems would also need to consider other factors, generally including: smaller time buckets, the calculation of taxes (including the cash flow timing), inflation, currency exchange fluctuations, hedged or unhedged commodity costs, risks of technical obsolescence, potential future competitive factors, uneven or unpredictable cash flows, and a more realistic salvage value assumption, as well as many others.
A more simple example of the net present value of incoming cash flow over a set period of time, would be winning a Powerball lottery of $500 million.
It is used to determine options which provide the best approach to achieving benefits while preserving savings in, for example, transactions, activities, and functional business requirements.
[29] A CBA may be used to compare completed or potential courses of action, and to estimate or evaluate the value against the cost of a decision, project, or policy.
For example, the U.S. Securities and Exchange Commission must conduct cost-benefit analyses before instituting regulations or deregulations.
It is calculated by dividing the negative NPV of a project by the "present value of annuity factor": where r is the annual interest rate and t is the number of years.
EAC is often used as a decision-making tool in capital budgeting when comparing investment projects of unequal lifespans.