Net Present Value

Net present value (NPV), is a standard method that is utilized to help determine if an investment should be made in a long term project. NPV is simply, “the value of a portfolio of financial instruments that track the project’s future cash flows, and the cost of implementing the project” (Financial Markets and Corporate Strategy, Grinblatt, Pg 331). In order to calculate the estimated cost of implementing a project, NPV uses present value (PV) to measure the cash flows, or more specifically, the surplus or lack of cash flows, once all financing charges have been paid.

The NPV evaluation method calculates cash flows through the use of formula (1).

\begin{align} \mbox{NPV} = \sum_{t=1}^{n} \frac{C_t}{(1+r)^{t}} - {C_0} \end{align}

t - the time of the cash flow
n - the total time of the project
r - the discount rate
Ct - the net cash flow at time t.
C0 - the capital outlay at t = 0

Utilizing formula (1), NPV depicts the measure of the excess or lack of cash flows by applying a positive or negative symbol to the result. A positive result indicates a project should be accepted because there will be a positive cash flow at the end of the defined period, t. A negative result indicates a project should be rejected because there will be a negative cash flow at the end of a defined period, t. The magnitude of the result is an estimation of the amount of that cash flow in either direction as a consequence of the investment project (Wikipedia, November 17, 2007).

NPV heavily relies on the discount rate in order to define the cash flows as some future time t. Because of the reliance by NPV on the discount rate, the investor must be careful to either be conservative with their discount rate estimates or perform a semi-elaborate study to accurately define the discount rates. This is not necessarily a limitation but a realization that needs to be made when an investor utilizes the NPV evaluation method.