When a business plans an expansion that requires substantial investment, key stakeholders must weigh the upfront cost against the estimated revenue the expansion will generate during the next several years. To do so, they use a calculation to determine what’s known as the investment’s net present value, measuring how much the future income is worth in today’s dollars.
Here is what you need to know about net present value, the NPV formula for calculating it, and how you can use it in your business.
What is net present value?
Net present value (NPV) is the difference between the money spent now on an investment and the money received in the future from that investment. The funds coming and going are typically referred to as cash flows. Future cash flows are reduced to their estimated present value using a process known as discounting.
If you’ve ever bet on a big lottery jackpot, then you are familiar with the idea of present value. The winner could take the full amount in a series of annual payments or take a lump sum that’s made up of the first payment and all the future annual payments reduced to their present value by some rate of interest.
Net present value revolves around two principles: the time value of money and the discount rate. The time value of money means simply that money received sooner is more valuable than money received later. The sooner you have it, the sooner you can invest it and earn a return. The more time you must wait to receive money from an investment, the more its future value is eroded by inflation and by opportunity cost, which is what you might have earned from a different investment.
The discount rate used to discount future cash flows is typically a rate of return that businesses or investors could reasonably expect from any investment. For instance, a minimum acceptable rate might be the prevailing interest rate for benchmark government bonds. Most often, a business bases the discount rate on the firm’s weighted average cost of capital (WACC) from debt and equity financing, which typically is higher than government bond rates.
What net present value can tell you
Net present value can help your business see, in dollar terms, whether investment opportunities such as buying new equipment, hiring more people, or creating a new product are likely to be profitable. In general, investments with a positive net present value—the discounted future cash flows are more than the investment’s cost—are worth undertaking, while those with a negative NPV are not. Positive NPV also signals that the investment’s internal rate of return (IRR) exceeds the cost of capital, a baseline for a successful investment.
Investors also use NPV for evaluating securities such as stocks and bonds, using financial modeling that discounts all expected cash flows, such as cash from operations, dividends, and interest income, to determine an appropriate trading price. For example, a stock might have discounted future cash flows on a per-share basis that exceed the company’s current market price, suggesting it’s undervalued and poised to rise. Corporate mergers and acquisitions also rely on an NPV calculation to determine business valuation and set a price for a purchase.
Limitations of net present value
- Depends on assumptions
- Doesn't consider the investment’s scale
- Ignores the rate of return
- Tedious manual process
Although the NPV formula and calculation can often help a business, it has some limitations:
Depends on assumptions
Net present value relies on assumptions about future expected cash flows, the discount rate to calculate their present value, and the cost of the investment. An NPV calculation is only as reliable as its underlying estimates.
Doesn't consider the investment’s scale
Although an NPV calculation results in a dollar figure, it doesn’t take into account the size of the upfront investment required. For example, say a hypothetical company looks at one investment idea with an NPV of $500,000 and another idea with an NPV of $50,000. The first idea looks more attractive, but it would require an initial $5 million investment, while the second idea would require only a $100,000 investment.
Ignores the rate of return
Net present value shows only a dollar amount, not a project’s return on investment (ROI) across the life of the investment, or the annualized internal rate of return, both of which are key measures of an investment’s efficiency. In the above example, the first idea would have a 10% return on investment, while the second would have a 50% ROI. To properly contextualize an NPV calculation, it’s worthwhile to consult these additional metrics.
Tedious manual process
If you’re working through the NPV formula by hand, each expected cash flow’s present value must be computed differently, using a compounded discount rate. The discounted cash flows must then be added up and subtracted from the cash outflow of the investment.
How to calculate NPV
- Determine your cash flows
- Select a discount rate
- Set a time period
- Calculate present value for future cash flows
- Calculate NPV
The NPV formula is the sum of a series of mathematical equations, each involving a discounted cash flow. The NPV formula has three components—cash flows, a discount rate, and a time period. Together, they allow you to calculate NPV:
1. Determine your cash flows
The first cash flow is negative, reflecting the cost of the investment. Subsequent cash flows are positive, showing money generated from the investment. Total up your investment cost and anticipated return.
2. Select a discount rate
The discount rate is typically what a company might reasonably expect to earn from an alternative investment had it not tied up money in the proposed investment. Many companies use WACC—a blend of the rates they pay for borrowing and the return expected by investors who provide equity funding. In finance, this is sometimes called the hurdle rate.
3. Set a time period
Net present value is based on discounting anticipated cash flows for future periods, which could be months, quarters, or years. Most companies calculate NPV using yearly intervals, figuring an investment will take at least a few years to bear fruit.
4. Calculate present value for future cash flows
Let’s start simple and assume there’s only one projected cash flow received one year from now. The future cash flow is divided by one plus the discount rate expressed as a decimal:
Present value = Expected future cash flow / (1 + Discount rate)
For a longer-term project with multiple cash flows expected across a span of years, the present value formula is more complicated. It’s the sum of the cash flows, each discounted by the rate compounded by the number of years of cash flow. That looks like this:
PV = Cash flow / (1 + Discount rate) + Cash flow/(1 + Discount rate^2) + Cash flow/(1 + Discount rate^3)
Here’s how a hypothetical business would use the present value formula for an investment. Let’s say Company A makes an initial investment of $5,000 and expects a cash flow of $10,000 from the investment one year from now. It uses a discount rate of 7%. The present value of the future $10,000 cash flow is:
PV = $10,000 / (1 + .07) = $9,345.80
5. Calculate NPV
To determine the investment’s net present value, subtract the initial investment cost from the present value of the discounted future cash flow. In the example, the initial investment is $5,000, and the present value of the future $10,000 cash flow is $9,345.80. Thus, the net present value is:
NPV = $9,345.80 – $5,000 = $4,345.80
This example aside, businesses usually don’t project a single cash flow. Instead, they estimate multiple cash flows across a longer time span. So let’s say Company A boosts its investment from $5,000 to $10,000 and now projects $10,000 in annual cash flows for three years. These flows are discounted at compound rates using the formula for present value:
$1,000 / 1.07 + $1,000 / 1.07^2 + $1,000 / 1.07^3
Using the NPV formula, the discounted cash flows calculation looks like this:
Year one: $10,000 / 1.07 = $9,345.80
Year two: $10,000 / 1.145 = $8,733.60
Year three: $10,000 / 1.225 = $8,163.30
So the present value of the three future cash flows is:
PV = $9,345.80 + $8,733.60 + $8,163.30 = $26,242.70
And the net present value is the sum of the discounted cash flows, minus the initial investment cost:
NPV = $26,242.70 – $10,000 = $16,242.70
NPV formula FAQ
What’s the NPV of $1,000 with a 10% discount rate over 10 years?
The net present value (NPV) of $1,000, which would be received in 10 years, is $385.54 when discounted by 10% compounded across that time span.
What are NPV and IRR?
NPV, or net present value, is the value today of an investment’s estimated future cash inflows, minus the investment’s upfront cost. IRR, or internal rate of return, is the annualized return on the NPV. Generally, a positive NPV indicates the IRR exceeds the cost of capital for the investment.
What is the difference between NPV and DCF?
Discounted cash flow, or DCF, is part of the NPV formula. A business estimates the future cash inflows (income) from a proposed investment and discounts them to a present value—what they’re worth in today’s dollars. Those cash inflows are then subtracted from the cash outflows, or the cost of investment, to calculate NPV.
