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## What is Net Present Value (NPV)?

NPV is a simple yet an important tool that shows the difference between the present value of future cash flows and the amount of current investment. The present value of your expected cash flow is derived by discounting them at a certain rate of return. NPV is an easy-to-use and simple to understand the tool and is a popular cash budgeting technique which is used to evaluate the suitability of investments and projects. An in-depth understanding of this concept helps to make sound investment decisions. In short, NPV is the residue obtained after deducting the present value of cash outflow from the present value of cash inflow. It is a comprehensive evaluation technique as it takes into account the effect of time on cash flows. It discounts the future cash flows to show its value in the present context.

## How is NPV calculated?

NPV tells you whether a certain project will generate cash flows according to your expectations or not. Using an assumed rate of return and investment horizon, it brings to light any adjustments required in your current investment to achieve a positive return.

NPV can be calculated by using the following formula:

NPV = [Cn/(1+r)^n], where n={0-N}

Where

Cn = difference of cash flows

r = discount rate

n = time in years

You need to follow selection criteria with regards to the usage of NPV. Calculation of NPV will result in three possible outcomes:

a.Positive NPV: In this situation, the present value of cash inflows is greater than the present value of cash outflows. This is an ideal situation for investment

b.Negative NPV: In this situation, the present value of cash inflows is less than the present value of cash outflows. This is not an ideal situation and any project with this NPV should not be accepted.

c.Zero NPV: In this situation, the present value of cash inflows equals the present value of cash outflows. You may or may not accept the project.

## What NPV doesn’t tell me?

NPV is a frequently used tool in the field of finance. But NPV doesn’t tell you everything that you need to know

It suffers from the following limitations:

a. NPV is based on a lot of assumptions and estimates. If any of the assumptions are wrong, the entire exercise of valuations will be rendered futile.

b. NPV doesn’t take into account risks inherent in an investment. This may lead to overestimation of the cash flows which can mislead the investors.

c. NPV ignores the possibilities of any escalations in the project cost in future. Sudden unforeseen expenditure may disbalance the entire projections.

## How is NPV different from IRR?

NPV is the difference between the present value of cash inflows and the present value of cash outflows. Internal Rate of Return (IRR) on the other hand is the discount rate which equates the present value of cash inflows with the present values of cash outflows. IRR is calculated by assuming that NPV equals to zero. It shows the breakeven point or the point where there’s neither profit nor loss. Conversely, NPV shows the excess inflows over the outflows.