Net Present Value (NPV)

Net Present Value (NPV) of Cash Flows

Net Present Value (NPV) discounts a project's expected cash flows to today's value and subtracts the initial investment. The formula is NPV = -I₀ + Σ CFₜ/(1+r)ⁿ, where I₀ is the upfront outlay, CFₜ is the cash flow in period t, and r is the discount rate (typically the cost of capital or WACC).

The decision rule is straightforward: accept the project if NPV > 0, reject if NPV < 0. A positive NPV means the project creates value beyond what the market would require for that risk level. NPV measures absolute value creation (in currency), while IRR measures rate of return (in percentage) — for mutually exclusive projects with different scales, NPV is the superior criterion.

Applications

Used in capital budgeting decisions: evaluating new plants, equipment purchases, M&A targets, real estate developments, R&D programs, and any project with a multi-period cash flow profile. Classic references include Brealey, Myers & Allen's Principles of Corporate Finance and Damodaran's valuation work.

FAQ

What discount rate should I use? Use the project's opportunity cost of capital — typically WACC for projects with the firm's average risk, or a risk-adjusted rate for atypical projects.

NPV vs IRR — which wins when they disagree? NPV. IRR can be misleading with non-conventional cash flows (multiple sign changes) or when comparing projects of different scale or duration.

Should I include sunk costs or financing cash flows? No. Sunk costs are irrelevant to the decision, and financing is already captured in the discount rate — use unlevered free cash flows discounted at WACC.