The net present value (NPV) is an investment criterion that consists of updating the cash inflows and outflows of a project or investment to determinate how much will be gained or lost with that investment.
To do this, it brings all cash flows to the present by discounting them at a certain interest rate. The NPV will express a measure of project profitability in absolute net terms, that is, in the number of monetary units (euros, dollars, pesos, etcetera).
Net present value (NPV) formula
The net present value (NPV) formula is used for the evaluation of different investment options. By calculating the NPV we will know with which of them we are going to obtain the highest profit.
where:
- Ft are the cash flows in each period t
- I0 is the initial investment made at time t=0
- n is the number of time periods
- k is the discount rate or interest rate required for the investment.
The NPV is used to generate two types of decisions: firstly, to determine if the investments are feasible and secondly, to determine which investment is better than another in absolute terms. The decision criteria are as follows:
- NPV > 0: The present value of future cash inflows and outflows of the investment, at the chosen discount rate, will generate profits.
- NPV = 0: The investment project will neither generate profits nor losses, making its realization, in principle, indifferent.
- NPV < 0: The investment project will generate losses, so it should be rejected.
Advantages and Disadvantages of NPV (Net Present Value)
Like any economic metric or indicator, Net Present Value (NPV) has advantages and disadvantages that are presented below:
Advantages of Net Present Value
NPV has several advantages when evaluating investment projects, mainly that it is an easy method to calculate and at the same time provides useful predictions about the effects of investment projects on the value of the company. In addition, it has the advantage of taking into account the different maturities of net cash flows.
Disadvantages of Net Present Value
Despite its advantages, NPV also has some disadvantages such as the difficulty of specifying a discount rate and the assumption of reinvestment of net cash flows (it is implicitly assumed that positive net cash flows are reinvested immediately at a rate that coincides with the discount rate, and that negative net cash flows are financed with resources whose cost is also the discount rate).
Example of NPV
Let us suppose we are offered an investment project in which we have to invest 5.000 euros and we are promised to receive 1.000 euros the first year, 2.000 euros the second year, 1.500 euros the third year and 3.000 euros the fourth year.
So the cash flows would be -5000/1000/2000/1500/3000
Assuming the discount rate is 3% per year, what will be the NPV of the investment?
To do this, we use the NPV formula:
The Net Present Value of the investment at this time is 1.894,24 euros. As it is positive, it is advisable to carry out the investment.
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