Net Present Value

Net Present Value

A project's net present value is determined by summing the net annual cash flow, discounted at the project's cost of capital and deducting the initial outlay. Decision criteria is to accept a project with a positive net present value. Advantages of this method are that it reflects the time value of money and maximizes shareholder's wealth. Its weakness is that its rankings depend on the cost of capital; present value will decline as the discount rate increases.

Payback Method

A company chooses the expected number of years required to recover an original investment. Projects will only be selected if initial outlay can be recovered within a predetermined period. This method is relatively easy since the cash flow doesn't need to be discounted. Its major weakness is that it ignores the cash inflows after the payback period, and does not consider the timing of cash flows.

Profitability Index

This is the ratio of the present value of project cash inflow to the present value of initial cost. Projects with a Profitability Index of greater than 1.0 are acceptable. The major disadvantage in this method is that it requires cost of capital to calculate and it cannot be used when there are unequal cash flows. The advantage of this method is that it considers all cash flows of the project.

Net Present Value

The sum of discounted costs are subtracted from the sum of discounted benefits. Projects with positive net present value should be considered; the greater the net present value, the more justifiable the project. However, a large project could have a higher net present value than a smaller project, even if it has a lower benefit-cost ratio.

In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity.

In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, above the cost of funds.

NPV can be described as the 'difference amount' between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) - is called the yield and is more widely used in bond trading.