Definition of NPV
NPV is the acronym for net present value, which can be calculated as follows:
- The present value of the future cash inflows
- Minus the cash investment
Example of NPV
Assume that a company makes a cash investment of $500,000 in a project that is expected to provide future cash inflows of $100,000 at the end of each year for 10 years.
The future cash receipts of $100,000 at the end of each year for 10 years needs to be discounted to their present value. If the future cash amounts are discounted by 14% per year compounded annually (the company’s required return), it will result in a present value of approximately $522,000.
The $522,000 of present value coming in minus the $500,000 of present value going out results is a positive net present value of $22,000. In other words, the company will earn slightly more than 14% per year on its $500,000 investment.
