What is net present value (NPV)?

Net present value (NPV) is defined as the difference between the present value of cash inflows and the present value of cash outflows associated with an investment or project. This measure is essential in capital budgeting and investment decision-making because it accounts for the time value of money.

When evaluating an investment, future cash flows are discounted back to their present value using a specific discount rate, typically reflecting the cost of capital or required rate of return. This process allows investors to assess the true profitability of the investment by recognizing that a dollar received in the future is worth less than a dollar received today. Therefore, compiling the present values of expected cash inflows and then subtracting the present values of anticipated cash outflows provides a clear indication of whether the investment will generate a positive return or not.

A positive NPV indicates that the projected earnings (adjusted for their current worth) exceed the anticipated costs, suggesting that the investment may be worthwhile. If NPV is negative, it signals that costs outweigh the benefits, making it an unattractive option. Thus, understanding NPV is crucial for effective financial analysis and strategic planning in business contexts.