Quick Summary
NPV helps evaluate the profitability of an investment by discounting future cash flows.
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of an investment.
NPV Formula
NPV = Σ [Cash Flow_t / (1 + r)^t] - Initial Investment
Where:
- r = discount rate
- t = time period
- Cash Flow_t = net cash flow in period t
Example
Project requiring ₹100 investment, discount rate 10%:
- Year 1: ₹40 / (1.10)^1 = ₹36.36
- Year 2: ₹50 / (1.10)^2 = ₹41.32
- Year 3: ₹60 / (1.10)^3 = ₹45.08
Total PV of inflows = ₹122.76
NPV = ₹122.76 - ₹100 = +₹22.76 (Accept)
Decision Rule
- NPV > 0: Accept (creates value)
- NPV = 0: Indifferent (returns exactly cost of capital)
- NPV < 0: Reject (destroys value)
Selecting Discount Rate
- Company's cost of capital (WACC)
- Required rate of return
- Risk-free rate + risk premium
- Higher risk projects need higher discount rates
Key Points
- Discounts future cash flows to present
- Positive NPV creates shareholder value
- Considers time value of money
- Dependent on discount rate selection
- Superior to payback period method