What is net present value?
Net present value (NPV) compares what a project costs today with the value today of the cash it will bring in. Each future cash flow is discounted at the required rate of return, then the initial investment is subtracted. It is the main capital budgeting method taught in managerial accounting and finance.
The formulas
Worked example
A machine costs $50,000 and saves $15,000 a year for 5 years. At 10%, the present value of the savings is $15,000 × 3.790787 = $56,861.80. NPV = $56,861.80 − $50,000 = $6,861.80, so the project is acceptable. The IRR is about 15.24% and the payback period is 3.33 years.
Frequently asked questions
What does a positive NPV mean?
The project earns more than the required rate of return, so it adds value. A negative NPV means it earns less, and it should usually be rejected.
What is IRR?
The internal rate of return is the discount rate that makes NPV exactly zero. If IRR is higher than the required return, NPV is positive.
What is the payback period?
The time it takes for cash inflows to repay the initial investment. It ignores the time value of money and any cash flows after payback, so it is used alongside NPV.
Can a project have no IRR or more than one?
Yes. If the cash flows change sign more than once (for example a large cost in a later year), there can be several IRRs or none. NPV is more reliable in those cases.