Definition of Net Present Value
Net present value is the combination of 1) the present value of cash inflows, and 2) the present value of the cash outflows. To arrive at these present value amounts, the future cash flows are discounted by a specified interest rate. The specified rate could be the investor’s cost of capital or it could be another hurdle rate that must be earned.
Advantages of using the net present value to evaluate investments include the following:
- All of an investment’s cash flows are used in the calculation
- The time value of money is recognized through the discounting of the future cash amounts
A project or investment that results in a net present value of $0 means that the project is expected to earn exactly the specified rate used to discount the future cash flows. A slightly negative net present value indicates that the project will earn slightly less than the specified rate. For instance, if the specified rate of 16% was used for discounting the cash flows, a slightly negative net present value could mean that the project is expected to earn slightly less than the required 16%. Perhaps the actual rate is expected to be 15.7% which may be a great return, but because it’s less than the required 16%, the investment will be rejected because of its negative net present value.
[To find the exact rate that a project is expected to earn, the project’s cash flows can be used to compute the internal rate of return, which is another discounted cash flow technique for evaluating investments.]
Example of Net Present Value
Assume a company is considering investing $100,000 today in a project that provides $30,000 at the end of each year for 5 years. The company’s hurdle rate is 20%. The present value of the $100,000 cash outflow is $100,000 (since it occurs at the present time). The present value of the $20,000 cash inflows occurring at the end of 7 years is $89,730 ($30,000 X 2.991). Therefore, the combination of the present values of the cash flows results in a net present value (NPV) of negative $10,270 (negative PV of $100,000 + positive PV of $89,730). The negative NPV means the investment will be rejected. However, the investment is expected to provide a return of approximately 15%.
