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Net present value (NPV) refers to the present value of cash flows expected. It is used to compare different investments, be they investments internal to a company, typically called projects, or external investments made by a company or an individual. Net present value is used because it can be difficult to compare investments, particularly when there are different investment values or different expected profits payable at different times. By using the present value of these estimated investments and expected profits, investments can be compared evenly and a decision made based on which is the most profitable.
In order to calculate the net present value of a project or investment, the value of expected profits must first be discounted to the present value. The rate by which expected profits are discounted is called the discount rate or hurdle rate. Typically, the discount rate is calculated by determining the amount of interest the investor could earn in the time period used – usually one year – if investing in a safer investment, such as letting the money earn interest in a savings account.
To calculate NPV, one first needs to determine what the forecasted cash flows are expected to be over the life of the investment, treating the initial investment as negative cash flow. Next, the discount rate should be determined by establishing what the rate of return would be if the safer investment was chosen. The discount rate is then used to discount the expected cash flows as follows.
NPV = C0 + [Ct / ((1+r)t)]
C0 is the initial capital outlay
Ct is the cash flow expected in a given time period (i.e. yearly)
r is the discount rate (the interest of the safe investment)
t is the time period (i.e. first year, second year)
When using net present value to evaluate the profitability of a project or investments, it typically should be remembered that this method assumes that conditions remain stable throughout the life of the project or investment, a scenario that rarely occurs in actuality. Also, the discount rate is based on an assumption of what the safe investment would be. A variety of methods may be used in determining the discount rate, from using the interest rate of a 10-year bond to applying the Capital Asset Pricing Model (CAP-M). Whatever method is used, a sensitivity analysis should be performed on the discount rate to see how much the profitability may differ between projects or investments given the different scenario.
Net present value is typically calculated tangent to the internal rate of return (IRR) of the same project or investment. The internal rate of return is calculated by determining the discount rate for which net present value would be zero. Although multiple solutions for internal rate of return will exist for each scenario, net present value may not always correlate with the internal rate of return, and internal rate of return has the disadvantage of using only one value for the entire time period, whereas the net present value can be calculated using different discount rates for different periods. Calculating the internal rate of return gives the evaluation of project or investment profitability further perspective.