Net Present Value (Npv) Definition
The Net Present Value (NPV) is the present value of all future cash flows from an investment, minus the initial investment. The NPV decision rule says to accept an investment with a positive NPV and to reject one with a negative NPV. All else being equal, the higher the NPV, the better.
To calculate NPV, we need to discount future cash flows back to their present value using a required rate of return. Then, we subtract the initial investment from this sum. This results in a positive or negative number that tells us whether an investment will add value or destroy it.
A positive NPV indicates that an investment will generate more money than it costs – in other words, it’s profitable. A negative NPV indicates that an investment will cost more than it generates – so it’s unprofitable.
In order for an investment to have a positive NPV, its return must be greater than the required rate of return. The required rate of return is also known as the discount rate or hurdle rate. It reflects how much return is required to compensate for the time value of money and the level of risk involved in an investment.
For example, let’s say you have two investments options:
Option 1: An up-front investment of $100 with no further cash flows.
Option 2: An up-front investment of $50 followed by a cash flow of
