What is net present value (NPV)?

Net Present Value (NPV) is defined as the difference between the present value of cash inflows and the present value of cash outflows over a specified period. It is a critical concept in finance used to evaluate the profitability of an investment or project.

When calculating NPV, future cash flows generated by the investment are discounted back to their present value using an appropriate discount rate. This discounting accounts for the time value of money, which recognizes that a dollar today is worth more than a dollar in the future due to its potential earning capacity. The cash outflows typically include the initial investment and any other costs associated with the project.

If the NPV is positive, it indicates that the investment is expected to generate more cash than it costs, making it a favorable opportunity. Conversely, a negative NPV suggests that the costs outweigh the expected returns.

Understanding NPV is essential for informed decision-making, as it provides a clear metric for assessing the financial viability of various projects or investments.