What is an NPV?
Net Present Value (NPV) is a financial measure used to determine if an investment will be profitable. It compares the current value of expected cash inflows with the initial investment. NPV takes into account the fact that money received in the future is worth less than money received today due to factors like inflation and the potential to return on investment (ROI). By discounting future cash flows back to their present value using a specified discount rate, NPV provides a clear indication of whether an investment will generate a positive or negative return. The NPV formula is
Net Present Value = Cash flow / (1 + i) ^ t – Initial Investment
here, ‘i’ will represent the discount rate, and t will represent the number of periods.
Key Features of NPV:
- Time Value of Money Consideration: NPV acknowledges that money received in the future is worth less than money received today due to the potential to earn returns on current funds.
- Absolute Dollar Value Assessment: The NPV provides a clear indication of the dollar value added by an investment project.
- Decision-Making Tool: NPV serves as a decision-making tool for evaluating the profitability and feasibility of investment projects.
Difference between NPV and IRR
In finance, there are two important ways to check if an investment is a good idea: Net Present Value (NPV) and Internal Rate of Return (IRR). NPV looks at the money you’ll get back from an investment compared to what you put in, while IRR figures out the percentage return you’ll get. NPV tells you how much money you’ll make or lose, while IRR tells you the percentage of profit. Both NPV and IRR help people decide if an investment is worth it or not. They’re like tools to see if an investment will make money or not.