What is net present value?

Net present value is the combination of the present value of an investment's cash inflows and the present value of the investment's cash outflows. To compute those present value amounts, the future cash flows are discounted by a specified rate. The specified rate could be the investor's cost of capital or it could be some other minimum rate that must be earned.

The advantages of using the net present value to evaluate investments are 1) all of the investment's cash flows are used in the calculation, and 2) the time value of money is considered because the future cash amounts are discounted to the present.

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 that was used in discounting 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 15.7%. (Hence, a project could earn a very respectable profit but have a negative net present value because it just missed achieving the specified rate.)

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.