What is net present value (NPV)?

Net present value (NPV) is defined as the difference between the present value of cash inflows and cash outflows. This calculation allows investors to assess the profitability of an investment or project over time by taking into account the time value of money.

When an investment generates future cash inflows, those inflows need to be discounted back to their present value using a specific discount rate, which typically reflects the investment’s risk and opportunity cost. Simultaneously, any cash outflows associated with the investment are also considered. By subtracting the present value of these cash outflows from the present value of cash inflows, NPV provides a clear indication of the net benefit of the investment. If the NPV is positive, it suggests that the investment is expected to generate more value than it costs, making it financially attractive. Conversely, a negative NPV would imply that the costs outweigh the benefits.

Understanding NPV is crucial for financial decision-making because it not only includes the amounts of cash flows but also factors in the timing of those cash flows, which is a core principle in finance.