Net Present Value Definition with Example
Net Present Value Definition – “The estimated current value of an investment, calculated by subtracting the cost of the investment from the present value of the investment’s future earnings”.
In simple words, it is the difference between the present value of cash inflows and present value of cash out flows. Or you can say that, NPV tells about the present value of the future receipts from the money invested today. It is one of the discounted cash flow method of capital budgeting. It is used to measure the profitability of the projects undertaken by the organization.
Net Present Value =
where, C0 = Initial investment
C = Cash Flows during the period t
r = discount rate
t = time
Net Present Value Example
Let’s understand Net present Value definition with the help of an example. XYZ Pvt Ltd is a company thinking of investing in a new project. The investment is Rs. 5,00,000. The first year cash flow is 1,00,00. Second year cash flow will be 2,50,000 and third year cash flow is 2,00,000. The cash flows are discounted @10%.
|Year||Cash Flow||Present Value|
|0||– 5,00,000||– 5,00,000|
|1||1,00,000||1,00,000×0.909 = 90,900|
|2||2,50,000||2,50,000 × 0.828 = 2,07,000|
|3||2,00,000||3,00,000 × 0.751 = 2,25,300|
NPV = Present Value of Cash flows -Initial investment
= 5,23,200 – 5,00,000
Interpretation of Net Present Value
If net present values is positive, that means the project has overcome the cost and has start making profit. In conclusion, positive NPV means, company should accept the project. However, if the NPV is negative, the organization should reject the project.
Discount rate a very important role in estimating the NPV. Companies identifies the discount rate with respect to returns, risk or the cost of borrowings. So, if discount rates are not selected appropriately, this could lead to wrongly estimation of NPV. At this point of time, various other capital budgeting methods are used such as Payback period, internal rate of return, etc.