How is net present value (NPV) calculated?

Net Present Value (NPV) is calculated by finding the difference between the present value of cash inflows and the present value of cash outflows over a specific time period. This approach provides a complete picture of the profitability of an investment by taking into account the time value of money, which acknowledges that a dollar received today is worth more than a dollar received in the future due to its potential earning capacity.

To calculate NPV, future cash inflows must first be discounted back to their present value using an appropriate discount rate, which reflects the risk associated with the investment and the opportunity cost of capital. The sum of these discounted inflows is then compared to the initial investment outlay (the cash outflow). If the present value of inflows exceeds the present value of outflows, the NPV will be positive, indicating that the investment may be considered good. Conversely, a negative NPV would suggest the investment may not be worthwhile.

This calculation is essential for decision-making in finance and investment, as it allows for an assessment of an investment's expected profitability compared to its cost.