NPV can be defined as a mathematical calculation that attempts to compare the value or amount of money invested today to the present value of future receipts that are likely to accrue from the investment. However, it’s worth noting that the comparison between cash flows takes into account the elements of inflation and interest rate. In other words, the net present value concept may be used to mean the value of money committed to a project as compared to the possible future inflows that a project could yield after such amounts are discounted using a specific rate of return. NPV can also be understood as a tool used to determine compound interest in a reverse manner. To get the present value of an investment, you need to discount the amount using the required rate of return.
NPV is a fundamental parameter in financial decisions that involve locking capital for many years in anticipation of future benefits when the project becomes productive. NPV is based on the time value of money principle. The value of a dollar received tomorrow is much less than the value of the same dollar received today. This phenomenon is because time has an impact on the value of cash flows. A cash flow today may be more valuable than an identical cash flow at some future time. It is true because current cash flows can be committed elsewhere and begin earning some returns, while a future cash flow cannot be invested until the future arrives. Net present value is computed by working out the negative cash flows or costs of a project and the positive cash flows (benefits) of a project in each period of the investment.
The investment period of a project is typically one year, but it can be split into phases, say, half-years, quarter-years and even months. NPV of a cash flow will be calculated by discounting the future value of such cash flows at the return dictated by the market. The NPV of a project is given by the total sum of the discounted future cash flows. The result from the addition of all the discounted cash flows will help you to make a conclusion on the decision between projects or whether a project meets your minimum standards. A positive NPV value with your chosen discount rate shows that the investment is viable, and it is worth implementation. On the other hand, a negative NPV value shows the project will result in a loss, thus cautioning management to drop the venture. A NPV Calculator can be found here.
NPV measures the excess or shortfall of cash flows above the cost of funds invested in present value terms. In light of this statement, every firm should pursue every investment opportunity with a positive NPV and discard any that shows a negative NPV. NPV, therefore, serve as an indicator to the management of how much value an investment or project adds to the firm.
Where NPV equals zero, the management should be indifferent on the direction to go, i.e. accept or reject the project. Such a project adds no value to the firm and decisions concerning such outcomes should be based on another criterion.
One of the shortcomings of NPV analysis is that comparisons between projects should not be made unless they have equal lives. Another weakness is the assumptions that have to be made. The discount rate used is an assumption that requires an educated guess of the cost of money and the effects of inflation. The future cash flows are another educated guess of expenses and revenues in the unknown future. However, wisdom is best served by using this very logical approach to capital decision making. The force of logic will be with you.