Net Present Value (NPV) answers the most fundamental question in capital allocation: does this investment create value or destroy it?
NPV = −Initial Investment + Σ [Cash Flow_t / (1 + r)^t]
Where r is the discount rate (cost of capital) and t is the year.
A positive NPV means the investment earns more than your required return. A negative NPV means it earns less. The rule: accept all positive-NPV projects.
Why we discount cash flows
A dollar today is worth more than a dollar in the future. If you can earn 10% per year, $1,000 today becomes $1,100 in one year. Equivalently, $1,100 in one year is worth $1,000 today at a 10% discount rate.
NPV applies this logic to all future cash flows from an investment: - Year 1 cash flow is discounted by (1 + r)^1 - Year 2 cash flow by (1 + r)^2 - And so on...
The sum of discounted cash flows, minus the initial investment, is the NPV.
A worked example
Investment: $100,000 Cash flows: $30k, $35k, $40k, $40k, $40k over 5 years Discount rate: 10%
| Year | Cash Flow | Discount Factor | Present Value |
|---|---|---|---|
| 1 | $30,000 | 1/1.10 = 0.909 | $27,273 |
| 2 | $35,000 | 1/1.21 = 0.826 | $28,926 |
| 3 | $40,000 | 1/1.331 = 0.751 | $30,053 |
| 4 | $40,000 | 1/1.464 = 0.683 | $27,321 |
| 5 | $40,000 | 1/1.611 = 0.621 | $24,837 |
| Total PV | $138,410 |
NPV = $138,410 − $100,000 = $38,410
Positive NPV → accept. This investment creates $38,410 in value above the required 10% return.
NPV decision rules
| NPV | Interpretation |
|---|---|
| Positive | Investment creates value — accept |
| Zero | Investment exactly meets required return |
| Negative | Investment destroys value — reject |
For competing projects with limited capital, rank by Profitability Index (PI = NPV/Investment).
The impact of the discount rate
The same $100k investment at different discount rates: - 5% discount rate → NPV = $62,948 - 10% discount rate → NPV = $38,410 - 15% discount rate → NPV = $18,141 - 20% discount rate → NPV = $1,285 - 22% discount rate → NPV = −$4,900 (project rejected)
The IRR (where NPV = 0) is approximately 21.5%.
Calculate NPV for your investment at the NPV Calculator.