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What is Net Present Value (NPV)?

NPV is a significant concept used in the financial domain. It is an easy-to-use and simple to understand tool which falls under the discounted cash flow (DCF) techniques.

NPV is a popular cash budgeting technique which is used to evaluate suitability of investments and projects. An in-depth understanding of the concept helps to make sound investment decisions.

NPV is the residual obtained after deducting the present value of cash outflow from 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 indicates the adjustment 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 a selection criteria as regards usage of NPV. After calculation of NPV, you will get one of the three results:

  • Positive NPV: In this situation, present value of cash inflows is greater than present value of cash outflows. This is an ideal situation. You can accept the project.

  • Negative NPV: In this situation, present value of cash inflows is less than present value of cash outflows. This is not an ideal situation. You should not accept the project.

  • Zero NPV: In this situation, present value of cash inflows is equal to 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 as much as you want to know.

It suffers from the following limitations:

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

  • 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.

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

How NPV is different from IRR?

NPV is the difference between present value of cash inflows and present value of cash outflows. Internal Rate of Return (IRR) is the discount rate which equates the present value of cash inflows with present values of cash outflows.

IRR is calculated by assuming NPV equal 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 out flows.