What Is Net Present Value (NPV)?
Formula, decision rule, and a step-by-step example.
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| Decision rule | Accept if NPV is positive; reject if negative |
|---|---|
| Needs | Cash flows, timing, discount rate (cost of capital) |
| Topic | Management accounting · Investment appraisal |
Net present value in plain English
Money received later is worth less than money today, because today’s money can be invested to earn a return. NPV converts every future cash flow to today’s value so they can be compared fairly with the cost of the project.
Worked example
A project costs 10,000 now and returns 6,000 at the end of year 1 and 6,000 at the end of year 2. The cost of capital is 10%.
| Year | Cash flow | Discount factor (10%) | Present value |
|---|---|---|---|
| 0 | (10,000) | 1.0000 | (10,000) |
| 1 | 6,000 | 0.9091 | 5,455 |
| 2 | 6,000 | 0.8264 | 4,958 |
| Net present value | 413 | ||
The NPV is about +413. It is positive, so the project earns slightly more than the 10% required return and should be accepted. Discount factors are rounded to four decimal places.
- Discounting the initial outlay at year 0. It happens now, so its factor is 1.
- Including depreciation or sunk costs. Use only future cash flows.
Frequently asked questions
What does a positive NPV mean?
The project earns more than the required rate of return, so it adds value and should normally be accepted.
What is the difference between NPV and IRR?
NPV is an amount of value created at a given discount rate. IRR is the discount rate at which NPV equals zero.
Why is NPV better than payback?
NPV uses all cash flows and the time value of money. Payback ignores cash flows after the payback date.
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