# Define: Net Present Value

### What is the dictionary definition of Net Present Value?

#### Dictionary Definition

Net present value (NPV) is a method for evaluating the profitability of an investment or project.

The net present value of an investment is the present (discounted) value of cash inflows minus the present value of cash outflows. Here’s an example of net present value: Suppose an investment requires an initial cash outflow of \$5,000 and provides cash inflows of \$4,000 in year 1 and \$3,000 in year 2. Without using net present value, simply toting up the cash flows sums to +\$2,000 (-\$5,000+4,000+3,000). With net present value and setting the discount rate to 10%, the investment is worth \$1,115.70. (Net present value can be calculated using the NPV function in Excel.) By recognizing the time value of money and equating dollars from different years, net present value makes it possible to evaluate long-term investments. Accurately estimating the cash inflows and outflows for the net present value calculation is tricky; selecting an appropriate discount rate for net present value is also difficult. Nevertheless, net present value is a valuable tool for analyzing capital projects and other investments.

#### Full Definition of Net Present Value

NPV or net present value can be obtained by subtracting the present value of cash outflows from the present value of cash inflows. It is used for analyzing the profitability of a project or investment in capital budgeting. A project can be undertaken if the result of NPV is positive. Net present value is susceptible to the consistency of the yield of future cash inflows of an investment or project.

The formula for calculation of NPV is: NPV = ∑t = 1T Ct / (1+ r) t − C0

Calculation of net present value is done by the following steps:

• Firstly, the expected free cash flows per year are calculated out of the investment.
• Secondly, adjustments can be done for the cost of capital through subtraction or discount. Here, it involves the adjustment of the rate of interest for risk and time.
• The intermediate result thus obtained is known as the present value.
• The third step involves the subtraction of initial investments.
• The final result obtained is now known as net present value.

### Capital Budgeting

Capital budgeting is a method of determining whether an investment on a project or a long-term venture should be taken up. It is also known as ‘investment appraisal’.

### Cost-benefit Analysis

It is a method of analyzing business decisions. Profits of action related to business or a given situation are added and then the costs involved with these actions are deducted.

### Discretionary Cash Flow

Discretionary cash flow is the leftover money after financing of capital projects with positive net present values and the disbursement of mandatory payments.

### Economic Value Of Equity

The economic value of equity or EVE is a cash flow calculation. It is obtained by taking all asset cash flows at present value and subtracting liability cash flows at present value. The economic value of equity is practised by banks for asset and liability management.

### Payback Period

Payback Period is the time length necessary to recover the investment cost. It is calculated as the payback period = cost of project /annual cash inflows.

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#### Definition Sources

Definitions for Net Present Value are sourced/syndicated and enhanced from:

• A Dictionary of Economics (Oxford Quick Reference)
• Oxford Dictionary Of Accounting
• Oxford Dictionary Of Business & Management

This glossary post was last updated: 27th March, 2020