What is Net Present Value (NPV)?

Published by Thomas Herold in Accounting, Corporate Finance, Investments, Real Estate

'Net Present Value (NPV)' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Net Present Value refers to a principal profitability measure that companies utilize in their corporate budget planning process. It helps them to analyze the possible ROI return on investment for a particular proposed or working project. Thanks to the involvement of time value and its depreciating effect on dollars, the NPV is forced to consider a discount rate and its compounding effect throughout the term of the entire project.

The actual Net Present Value in an investment or business project considers the point where revenue (or cash inflow) is equal to or greater than the total investment capital that funds the project or asset in the first place. This is particularly useful for businesses when they are comparing and contrasting a number of different projects or potential projects. It allows them to draw a valuable comparison of their comparative profitability levels to make sure that they only spend their limited resources, time, and management skills on the most valuable ventures. The higher the NPV proves to be, the more profitable it is as an investment, property, or project in the end.

Another way of thinking about the Net Present Value is as a measurement of how well an investment is meeting a targeted yield considering the upfront investment that the firm made. Using this NPV, companies can also determine precisely what adjustment they need in the initial investment in order to reach the hoped for yield. This assumes that all else remains constant.

Net Present Value can also be utilized to effectively visualize and quantify investments in real estate and other asset purchases in a simple formulaic expression. This is that the NPV is equal to the Current value minus the cost. In this iteration of the NPV, the current value of all anticipated future cash flow is discounted to today utilizing the relevant discount rate minus the cost of acquiring said cash flow. This makes NPV essentially the value of the project less the cost. When analysts or corporate accountants examine the NPV in this light, it becomes easy to understand how the value explains if the item being purchased (or project being funded) is more or less valuable than the cost of it in the first place.

Only three total categories of NPV ultimate values are possible for any property purchase or project funding. NPV could be a positive Net Present Value. This means that the buyers will pay less than the true value of the asset. The NPV might also be a Zero NPV. This simply means that the buyer or project funder is paying precisely the value of the asset or project worth. With a negative NPV in the final categorization, the buyer will be paying too much for the asset technically. This will be more than the asset is actually worth. There are cases where companies or buyers might be willing to pursue a project or acquire an asset with a negative NPV when other factors come into play.

For example, they might be interested in purchasing a property for a new corporate headquarters whose NPV is negative. The reasoning behind such a decision could be the unquantifiable and intangible value of the location of the property either for visibility purposes or because it is next to the present company headquarter premises.

It is always helpful to look at a concrete example to de-mystify difficult concepts like Net Present Value. Consider a corporation that wishes to fully analyze the anticipated profits in a project. This given project might need an upfront $10,000 investment to get it off the ground. In three years time, the project is forecast to create revenues amounting to $2,000, $8,000, and $12,000. This means that the project is expected to provide $22,000 on the initial $10,000 outlay.

It would appear that the return will amount to 120 percent for a gain greater than the initial investment. There is a reason why this is not the case though. The discount rate for the time value of money has to be factored in, and this means a percentage of several points per year at least. The figure of 4.5 percent is often utilized on a three year project like this. This takes into consideration the fact that dollars earned three years from now will not be so valuable as today’s earned dollars. This is why the corporate accountants will use business calculators in order to plug in the discount time value rates to figure the true NPV. Discounting by the 4.5 percent means that the project actually will return somewhere near $21,000 in terms of today’s dollar value.

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The term 'Net Present Value (NPV)' is included in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.