💰 Net Present Value (NPV)
Big Idea: NPV calculates the present value of all future cash flows from an investment, minus the initial cost. It accounts for the fact that money today is worth more than the same amount in the future (time value of money).
NPV = Sum of [net cash flow x discount factor] for each year - initial investment
- Positive NPV = investment earns MORE than the required rate of return — ACCEPT
- Negative NPV = investment earns LESS than the required rate of return — REJECT
- NPV of zero = investment earns EXACTLY the required rate — breakeven
🔢 Calculating NPV
Investment: $100,000 now. Returns: Year 1 = $40,000, Year 2 = $50,000, Year 3 = $40,000. Discount rate = 10%.
Year 0: -$100,000 x 1.000 = -$100,000 Year 1: $40,000 x 0.909 = $36,360 Year 2: $50,000 x 0.826 = $41,300 Year 3: $40,000 x 0.751 = $30,040
NPV = -$100,000 + $36,360 + $41,300 + $30,040 = +$7,700
Positive NPV — accept the investment!
Discount factors will be given in the exam — you do not need to calculate them. Just multiply each year''s cash flow by the given discount factor.
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Evaluating NPV
Advantages
- Considers the time value of money (unlike payback period)
- Uses ALL cash flows over the project''s life (unlike payback)
- Gives a clear decision rule: positive = accept, negative = reject
- Can compare projects of different sizes and durations
Disadvantages
- Complex to calculate and understand
- Relies on estimated future cash flows — which may be inaccurate
- The choice of discount rate is subjective and significantly affects the result
- Difficult to explain to non-financial managers