Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Net Present Value (NPV)

What it is:

Net present value (NPV) is the present value of an investment's expected cash inflows minus the costs of acquiring the investment.

How it works (Example):

The formula for NPV is:

NPV = (Cash inflows from investment) – (cash outflows or costs of investment)

Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company ABC's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of purchasing Company ABC.

[To learn how to calculate present value (PV), be sure to read A Primer on Present Value and Its Many Uses]

Cost to purchase Company ABC today: $1,000,000

Present value (PV) of cash flows from acquiring Company ABC:

Year 1: $200,000

Year 2: $150,000

Year 3: $100,000

Year 4: $75,000

Year 5: $70,000

Year 6: $55,000

Year 7: $50,000

Year 8: $45,000

Year 9: $30,000

Year 10: $10,000

Total: $785,000

Now that we know the total cash flow for the next 10 years (the total cash inflows from the investment), along with total cost of the investment in Company ABC, we can use the formula to calculate NPV:

Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000

At this point, management for Company XYZ would use the net present value rule to decide whether or not to pursue the acquisition of Company ABC. Because the NPV is negative, they should say, "No."

Why it Matters:

NPV is used to analyze an investment decision and give company management a clear way to tell if the investment will add value to the company. Typically, if an investment has a positive net present value, it will add value to the company and benefit company shareholders.

Net present value calculations can be used for either acquisitions (as shown in the example above) or future capital projects. For example, if a company decides to open a new product line, they can use NPV to find out if the projected future cash inflows cover the future costs of starting and running the project. If the project has a positive NPV, it adds value to the company and therefore should be considered.

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