NPV

Net present value (NPV) is a financial metric used in capital budgeting to assess the profitability of an investment or project. It measures the difference between the present value of expected cash inflows and the present value of expected cash outflows over the project’s life.

NPV is calculated by discounting each expected cash flow at a chosen rate r and summing these present values, then subtracting the initial outlay. In formula form, NPV = Σ_t CF_t / (1 + r)^t − I_0, where CF_t represents net cash flow at time t and I_0 is the initial investment. A positive NPV indicates the project is expected to create value above the required return, while a negative NPV suggests value destruction. When NPV is zero, the project earns the exact rate of return implied by the discount rate.

The discount rate r reflects the opportunity cost of capital and the project’s risk. It is often based on the firm’s cost of capital or a risk-adjusted rate and may incorporate inflation, financing costs, and required returns. NPV relies on cash flow estimates and the chosen rate, and its conclusions depend on these inputs.

NPV is primarily used to rank and select among projects. Among mutually exclusive alternatives, the one with the highest NPV is preferred when cash flows are accurately estimated. Strengths include accounting for the time value of money and using all cash flows. Limitations include sensitivity to input assumptions, the need for reliable forecasts, and potential scale biases if comparing projects of different sizes or lifespans.