Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment by comparing the present value of cash inflows and outflows. It accounts for the time value of money, which means future cash flows are discounted to their present values. The NPV calculation involves several steps:
Identify Cash Inflows and Outflows: List all expected cash flows associated with the investment over its projected lifespan.
Determine the Discount Rate: Select a rate of return to discount future cash flows. This rate often reflects the cost of capital or required rate of return.
Calculate Present Value: Discount each future cash flow to its present value using the formula:
where C is the cash flow, r is the discount rate, and n is the period. Sum the Present Values: Add up all the present values of the cash flows.
Subtract Initial Investment: The resulting value is the NPV.
Where Ct is the cash flow at the time t , r is the discount rate, and C0 is the initial investment. A positive NPV indicates a profitable investment, while a negative NPV suggests a loss.