What is net present value (NPV)?

Net present value (NPV) is a way of working out the profitability of investments, projects, or business ventures. By discounting future cash flows to their present value, NPV tells you whether a venture is financially viable in the long term.

On this page, you’ll find answers to some of the most frequently asked questions, including how to calculate NPV, what a positive or negative result means, and examples of net present value.

Net present value (NPV), also known as net present worth, is a way of working out the value of an investment today by considering all the money it’s expected to make in the future. It’s a bit like asking: “What’s the value of all the future cash I expect to receive, in today’s money?”

NPV calculates the difference between the money you expect to receive from an investment and the money you expect to spend on it, all adjusted for today’s value. The NPV formula is often used in investment planning, accounting, and capital budgeting, helping businesses and finance experts work out if a project or investment is profitable and where to invest their money. The net present value technique ultimately helps you decide if it’s worth it in the long run by calculating if the investment will generate more money than you put in.

Where NPV stands out from other methods is that it takes into account the time value of money, which is basically how the value of money changes over time. Because the NPV equation factors in aspects like inflation and interest rates, you can also use NPV to see whether your pension contributions are likely to provide you with enough money for retirement.

To calculate the net present value of an investment or project, you follow these steps:

1. Determine the cash flows expected for each period of the investment.
2. Discount these cash flows to their present value using a discount rate.
3. Subtract the initial investment from the sum of the discounted cash flows.

This is the net present value formula for a single cash flow:

NPV = cash flow / (1 + i)^t – initial investment.

i = discount rate

t = time in years

The cash flow in the NPV formula refers to the amount of cash inflows once you’ve subtracted any cash outflows, such as operational expenses, maintenance costs, etc. To put it simply, NPV is equal to today’s value of expected cash flows minus today’s value of invested cash.

You don’t have to struggle with calculating this yourself. To compute net present value quickly and easily, you can find a wide range of NPV calculators online. You can also calculate net present value using Excel - the function is already installed, you simply have to input your cost streams.

The discount rate is a central element of the net present value formula, and it varies for each company. In very simple terms, the discount rate is the minimum rate of return that a project needs to achieve to be considered a good investment. The discount rate accounts for interest rates and inflation, as well as opportunity costs, which are the potential benefits or profit you miss when choosing one investment over another. 

Say you were given the choice to receive either £100 today or £105 in a year. You might wait if no better investment is available. However, if you had another opportunity to earn 8% interest with no risk, waiting for the £105 wouldn’t make sense. In this case, the discount rate in the NPV equation would be the 8% interest rate.

The risk level of an investment also influences the discount rate. In other words: how likely is the investment to generate returns? For instance, investing in government bonds in the UK could be seen as lower risk, and therefore have a lower discount rate, compared to investing in a new startup. Analysts will typically use a method called discounted cash flow (DCF) analysis, which includes revenues, expenses, and capital costs, to put a value on a business or investment. 

For some pensions, such as defined benefit schemes, the discount rate is based on how much the pension fund is expected to earn from its investments. Those in charge of the scheme look at where the funds are invested (e.g., stocks, bonds, property) and long-term economic trends. This helps them to determine the discount rate that will be used to calculate the value of the pension benefits.

Now we’ve provided a definition of NPV, it can help to illustrate the method with examples. 

Let’s start with an investment scenario. Suppose you invest £10,000 today and an additional £10,000 in two years. In return, you expect to receive £12,500 in cash flows over the next five years and another £12,500 in ten years.

Now, let’s add the discount rate to the net present value equation, set at 4% (1.04). Here’s how you calculate the present value of each investment:

The £10,000 invested today remains the same, since it’s already in the present.

For the £10,000 invested in two years, its present value is £9,245 due to the discount rate.

Next, calculate the present value of the payouts you expect to receive:

£12,500 / ((1.04) ^ 5) = £10,274.09. The £12,500 you expect in five years is worth £10,274.09 today.

£12,500 / ((1.04) ^ 10) = £8,444.55. The £12,500 you expect in ten years is worth £8,444.55 today.

Now, add up the present values of your payouts and subtract the present values of your investments.

You find that your NPV is -£896.74. This implies the investment is producing a negative return. In this case, it might be wiser to seek alternative investment opportunities.

Net present value (NPV) isn’t just for investments; we can also use the first part of the NPV equation, the present value, to calculate retirement savings. When calculating your pension funds, the future purchasing power of your savings will be impacted by inflation, among other factors.

Inflation tends to erode the value of money over time, so the same amount of money won’t buy as much in the future. 

To illustrate this, suppose you’ve been saving for retirement and expect to have £120,000 in your pension account when you retire in 10 years. 

Assuming an inflation rate of 2%, we can use the NPV calculation formula to calculate today’s value:

Present value = £120,000 / (1.02^10) = £98,442

This calculation shows that, due to inflation, the current value of your £120,000 pension in today’s terms is approximately £98,442. This means if you want your retirement savings to maintain their purchasing power in the future, you may need to save additional funds to counteract the effects of inflation.

A good NPV is usually one that is greater than zero. This means that after considering factors like your cost of capital, opportunity cost, and risk tolerance, the project is expected to generate returns higher than its initial investment. So, if you’re looking at a project and its NPV is positive, it’s generally a sign that it’s worth pursuing, as it should yield profitable returns.

• Negative NPV: A negative net present value means the project’s expected returns are lower than what’s needed to break even, indicating a potential loss. Even if the project generates some income, it’s probably not enough to cover the costs and meet the expected return rate.
• Positive NPV: A positive NPV signals that the project’s expected returns are higher than the required rate, making it financially viable. The project is likely to make enough income to cover costs and provide additional value, generating a profit for the investor.

IRR (internal rate of return) is the rate at which the net present value of an investment becomes zero. It represents the annual return an investor expects from an investment. Ideally, investors want the IRR to be higher than the discount rate.

NPV and IRR can be used together, along with other factors, to help investors and managers decide whether an investment is worthwhile. So, when it comes to which is better, that really depends on specific circumstances and preferences, as each has its strengths and limitations. 

While the net present value formula is generally preferred for its comprehensive approach, some investors prefer combining methods for a more detailed assessment. This may include simpler methods like the payback period, which calculates the time to achieve a return on investment (ROI). It can certainly be useful for quick comparisons, but the payback period on its own doesn’t always tell the whole story.

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