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Understanding Net Present Value

Understanding Net Present Value

What is Net Present Value?

In finance, the net present value time series of cash flows, both incoming and outgoing flows, refers to the sum of the present values of the individual cash flows. The net present value is a fundamental indicator in discounted cash flow analysis; the NPV is a effective in using the time value of money to appraise long-term investment opportunities or projects. The net present value calculation is also used for capital budgeting purposes and widely throughout finance, economics and accounting, the figure is used to measure the excess or shortfall of cash values, once all financing charges are satisfied. When all future cash flows are incoming and the only outflow is represented by the purchase price, the net present value is simply the present value of the future cash flows minus the purchase price.

In general, the net present value refers to the present value of cash flows that are expected by a business model. The net present value formula is used to compare different types of investments, particularly in those situations where different investment values or different expected profits are to be expected at different times. By using the net present value of estimated investments and expected profits, a company’s investment plan can be compared evenly—this ultimately enables the company to render a decision on which investment route to proceed with. 

What is the Net Present Value Formula?

Each cash inflow and outflow is discounted back to its present value, and then summed together. As a result, the net present value is the sum of all terms: R(T)/(1+i)^t. In this equation, t= the time of the cash flow, i=the discount rate, which refers to the rate of return that could be earned on investing in securities with with similar variables and risk), R(t)= the net cash flow or the amount of cash, inflow minus the outflow at the time of t. The rate utilized to discount future cash flows to a present value is a fundamental variable in the net present value process. The discount rate will fluctuate based on the firm’s business model. Several firm’s will use their weighted average cost of capital; however, several economists and investors think that it is appropriate to use a higher discount rate in order to adjust for risk or other external factors.