Net Present Value (NPV)

Net Present Value is the sum of all future cash flows discounted to today's value, minus the initial investment. If it is positive, a project generates more than it costs. It helps decide whether an investment is worthwhile. The underlying idea is the time value of money: a euro available today is worth more than a euro in five years, because it can be invested in the meantime and because future payments are uncertain.

The discount rate expresses both and is derived in company valuations from the weighted average cost of capital, and for individual projects often from an internally set hurdle rate. The decision rule is simple: a positive net present value means the project exceeds the required return and creates value. Compared with the internal rate of return, net present value has methodological advantages, because it measures in monetary units and therefore reflects the size of a project, because it assumes reinvestment at the cost of capital rather than at the internal rate of return, and because it remains unambiguous even where the cash flow series changes sign.

In practice the internal rate of return is nevertheless often preferred, because a percentage is easier to compare and communicate. In the discounted cash flow method, operating enterprise value is the present value of future free cash flows to the firm. The net present value of a specific acquisition would additionally deduct the corresponding purchase price. Formally the net present value is the sum of the cash flows discounted to the valuation date, that is the sum of all CF t divided by one plus i to the power of t, less the initial outlay.

The choice of discount rate is decisive, as it should reflect the return on the best comparable alternative at the same level of risk. Small changes to that rate shift the result considerably, because payments far in the future are heavily discounted. It is therefore common to calculate the net present value for several rates and scenarios and to report the range rather than a single figure.