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Table of Contents
What Is Net Present Value (NPV)?
Formula
Positive NPV vs. Negative NPV
How to Calculate NPV Using Excel
Example of Calculating NPV
Limitations
NPV vs. Payback Period
NPV vs. Internal Rate of Return
Why Is Net Present Value Important?
Is A Higher or Lower NPV Better?
Net Present Value FAQs
Is NPV or ROI More Important?
What Is the Difference Between NPV and ROI?
What Happens to NPV When Interest Rate Increases?
Why Should you Choose a Project With a Higher NPV?
CORPORATE FINANCE FINANCIAL RATIOS
Net Present Value (NPV): What It Means and Steps to Calculate It
What you need to know about differences over time

By JASON FERNANDO Updated May 31, 2024

Reviewed by JULIUS MANSA
Fact checked by VIKKI VELASQUEZ
What Is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time. NPV is used in
capital budgeting and investment planning to analyze the profitability of a
projected investment or project.

NPV is the result of calculations that find the current value of a future stream of
payments using the proper discount rate. In general, projects with a positive NPV
are worth undertaking, while those with a negative NPV are not.
1

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KEY TAKEAWAYS
Net present value (NPV) is used to calculate the current value of a future stream
of payments from a company, project, or investment.
To calculate NPV, you need to estimate the timing and amount of future cash flows
and pick a discount rate equal to the minimum acceptable rate of return.
The discount rate may reflect your cost of capital or the returns available on
alternative investments of comparable risk.
If the NPV of a project or investment is positive, it means its rate of return will
be above the discount rate.
Net Present Value (NPV)
Investopedia / Julie Bang

Net Present Value (NPV) Formula

If there’s one cash flow from a project that will be paid one year from now, then
the calculation for the NPV of the project is as follows:

𝑁
𝑃
𝑉
=
Cash flow
(
1
+
𝑖
)
𝑡
−
initial investment
where:
𝑖
=
Required return or discount rate
𝑡
=
Number of time periods

NPV=
(1+i)
t

Cash flow

−initial investment
where:
i=Required return or discount rate
t=Number of time periods

If analyzing a longer-term project with multiple cash flows, then the formula for
the NPV of the project is as follows:

𝑁
𝑃
𝑉
=
∑
𝑡
=
0
𝑛
𝑅
𝑡
(
1
+
𝑖
)
𝑡
where:
𝑅
𝑡
=
net cash inflow-outflows during a single period
𝑡
𝑖
=
discount rate or return that could be earned in alternative investments
𝑡
=
number of time periods

NPV=
t=0
∑
n

(1+i)
t

R
t

where:
R
t

=net cash inflow-outflows during a single period t

i=discount rate or return that could be earned in alternative investments
t=number of time periods

If you are unfamiliar with summation notation, here is an easier way to remember
the concept of NPV:
1

𝑁
𝑃
𝑉
=
Today’s value of the expected cash flows
−
Today’s value of invested cash
NPV=Today’s value of the expected cash flows−Today’s value of invested cash

What NPV Can Tell You

NPV accounts for the time value of money and can be used to compare the rates of
return of different projects or to compare a projected rate of return with the
hurdle rate required to approve an investment.
2
The time value of money is represented in the NPV formula by the discount rate,
which might be a hurdle rate for a project based on a company’s cost of capital,
such as the weighted average cost of capital (WACC). No matter how the discount
rate is determined, a negative NPV shows that the expected rate of return will fall
short of it, meaning that the project will not create value.
1
3

In the context of evaluating corporate securities, the net present value

calculation is often called discounted cash flow (DCF) analysis. It’s the method
used by Warren Buffett to compare the NPV of a company’s future DCFs with its
current price.
4

The discount rate is central to the formula. It accounts for the fact that, as long
as interest rates are positive, a dollar today is worth more than a dollar in the
future. Inflation erodes the value of money over time. Meanwhile, today’s dollar
can be invested in a safe asset like government bonds; investments riskier than
Treasurys must offer a higher rate of return. However it’s determined, the discount
rate is simply the baseline rate of return that a project must exceed to be
worthwhile.

For example, an investor could receive $100 today or a year from now. Most
investors would not be willing to postpone receiving $100 today. However, what if
an investor could choose to receive $100 today or $105 in one year? The 5% rate of
return might be worthwhile if comparable investments of equal risk offered less
over the same period.

If, on the other hand, an investor could earn 8% with no risk over the next year,
then the offer of $105 in a year would not suffice. In this case, 8% would be the
discount rate.

Positive NPV vs. Negative NPV

A positive NPV indicates that the projected earnings generated by a project or
investment—discounted for their present value—exceed the anticipated costs, also in
today’s dollars. It is assumed that an investment with a positive NPV will be
profitable.

An investment with a negative NPV will result in a net loss. This concept is the
basis for the net present value rule, which says that only investments with a
positive NPV should be considered.
1

NPV can be calculated using tables, spreadsheets (for example, Excel), or financial
calculators.

How to Calculate NPV Using Excel

In Excel, there is an NPV function that can be used to easily calculate the net
present value of a series of cash flows. This is a common tool in financial
modeling. The NPV function in Excel is simply NPV, and the full formula requirement
is:

=NPV(discount rate, future cash flow) + initial investment

NPV Example
NPV Example, Excel.
In the example above, the formula entered into the gray NPV cell is:

=NPV(green cell, yellow cells) + blue cell

= NPV(C3, C6:C10) + C5
Example of Calculating NPV
Imagine a company can invest in equipment that would cost $1 million and is
expected to generate $25,000 a month in revenue for five years. Alternatively, the
company could invest that money in securities with an expected annual return of 8%.
Management views the equipment and securities as comparable investment risks.

There are two key steps for calculating the NPV of the investment in equipment:
Step 1: NPV of the Initial Investment
Because the equipment is paid for up front, this is the first cash flow included in
the calculation. No elapsed time needs to be accounted for, so the immediate
expenditure of $1 million doesn’t need to be discounted.

Step 2: NPV of Future Cash Flows

Identify the number of periods (t): The equipment is expected to generate monthly
cash flow for five years, which means that there will be 60 periods included in the
calculation after multiplying the number of years of cash flows by the number of
months in a year.
Identify the discount rate (i): The alternative investment is expected to return 8%
per year. However, because the equipment generates a monthly stream of cash flows,
the annual discount rate needs to be turned into a periodic, or monthly, compound
rate. Using the following formula, we find that the periodic monthly compound rate
is 0.64%.
Periodic Rate
=
(
(
1
+
0
.
0
8
)
1
1
2
)
−
1
=
0
.
6
4
%
Periodic Rate=((1+0.08)
12
1

)−1=0.64%

Assume the monthly cash flows are earned at the end of the month, with the first
payment arriving exactly one month after the equipment has been purchased. This is
a future payment, so it needs to be adjusted for the time value of money. An
investor can perform this calculation easily with a spreadsheet or calculator. To
illustrate the concept, the first five payments are displayed in the table below.

Image
Image by Sabrina Jiang © Investopedia 2020
The full calculation of the present value is equal to the present value of all 60
future cash flows, minus the $1 million investment. The calculation could be more
complicated if the equipment was expected to have any value left at the end of its
life, but in this example, it is assumed to be worthless.

𝑁
𝑃
𝑉
=
−
$
1
,
0
0
0
,
0
0
0
+
∑
𝑡
=
1
6
0
2
5
,
0
0
0
6
0
(
1
+
0
.
0
0
6
4
)
6
0
NPV=−$1,000,000+∑
t=1
60

(1+0.0064)
60

25,000
60
That formula can be simplified to the following calculation:

𝑁
𝑃
𝑉
=
−
$
1
,
0
0
0
,
0
0
0
+
$
1
,
2
4
2
,
3
2
2
.
8
2
=
$
2
4
2
,
3
2
2
.
8
2
NPV=−$1,000,000+$1,242,322.82=$242,322.82

In this case, the NPV is positive; the equipment should be purchased. If the
present value of these cash flows had been negative because the discount rate was
larger or the net cash flows were smaller, then the investment would not have made
sense.

Limitations of NPV
A notable limitation of NPV analysis is that it makes assumptions about future
events that may not prove correct. The discount rate value used is a judgment call,
while the cost of an investment and its projected returns are necessarily
estimates. The NPV calculation is only as reliable as its underlying assumptions.
5
1

The NPV formula yields a dollar result that, though easy to interpret, may not tell
the entire story. Consider the following two investment options: Option A with an
NPV of $100,000, or Option B with an NPV of $1,000.

NPV Formula
Pros
Considers the time value of money

Incorporates discounted cash flow using a company’s cost of capital

Returns a single dollar value that is relatively easy to interpret

May be easy to calculate when leveraging spreadsheets or financial calculators

Cons
Relies heavily on inputs, estimates, and long-term projections

Doesn’t consider project size or return on investment (ROI)

May be hard to calculate manually, especially for projects with many years of cash
flow

Is driven by quantitative inputs and does not consider nonfinancial metrics

NPV vs. Payback Period

Easy call, right? How about if Option A requires an initial investment of $1
million, while Option B will only cost $10? The extreme numbers in the example make
a point. The NPV formula doesn’t evaluate a project’s return on investment (ROI), a
key consideration for anyone with finite capital. Though the NPV formula estimates
how much value a project will produce, it doesn’t show if it's an efficient use of
your investment dollars.
The payback period, or payback method, is a simpler alternative to NPV. The payback
method calculates how long it will take to recoup an investment. One drawback of
this method is that it fails to account for the time value of money. For this
reason, payback periods calculated for longer-term investments have a greater
potential for inaccuracy.

Moreover, the payback period calculation does not concern itself with what happens
once the investment costs are nominally recouped. An investment’s rate of return
can change significantly over time. Comparisons using payback periods assume
otherwise.
3

NPV vs. Internal Rate of Return (IRR)

The internal rate of return (IRR) is calculated by solving the NPV formula for the
discount rate required to make NPV equal zero. This method can be used to compare
projects of different time spans on the basis of their projected return rates.
3

For example, IRR could be used to compare the anticipated profitability of a three-
year project with that of a 10-year project. Although the IRR is useful for
comparing rates of return, it may obscure the fact that the rate of return on the
three-year project is only available for three years, and may not be matched once
capital is reinvested.

Why Is Net Present Value Important?

Net present value is important because it allows businesses and investors to assess
the profitability of a project or investment, taking into account the average cost
of capital and the expected rate of return. By discounting future cash flows to
their present value, NPV helps in making informed choices, ensuring that undertaken
projects contribute positively to the overall financial health and growth.

Is A Higher or Lower NPV Better?

A higher value is generally considered better. A positive NPV indicates that the
projected earnings from an investment exceed the anticipated costs, representing a
profitable venture. A lower or negative NPV suggests that the expected costs
outweigh the earnings, signaling potential financial losses. Therefore, when
evaluating investment opportunities, a higher NPV is a favorable indicator,
aligning with the goal of maximizing profitability and creating long-term value.

What Does Net Present Value (NPV) Mean?

Net present value (NPV) is a financial metric that seeks to capture the total value
of an investment opportunity. The idea behind NPV is to project all of the future
cash inflows and outflows associated with an investment, discount all those future
cash flows to the present day, and then add them together. The resulting number
after adding all the positive and negative cash flows together is the investment’s
NPV. A positive NPV means that, after accounting for the time value of money, you
will make money if you proceed with the investment.

What Is the Difference Between NPV and Internal Rate of Return (IRR)?
NPV and internal rate of return (IRR) are closely related concepts, in that the IRR
of an investment is the discount rate that would cause that investment to have an
NPV of zero. Another way of thinking about the differences is that they are both
trying to answer two separate but related questions about an investment. For NPV,
the question is, “What is the total amount of money I will make if I proceed with
this investment, after taking into account the time value of money?” For IRR, the
question is, “If I proceed with this investment, what would be the equivalent
annual rate of return that I would receive?”

What Is a Good NPV?

In theory, an NPV is “good” if it is greater than zero. After all, the NPV
calculation already takes into account factors such as the investor’s cost of
capital, opportunity cost, and risk tolerance through the discount rate. And the
future cash flows of the project, together with the time value of money, are also
captured. Therefore, even an NPV of $1 should theoretically qualify as “good,”
indicating that the project is worthwhile. In practice, since estimates used in the
calculation are subject to error, many planners will set a higher bar for NPV to
give themselves an additional margin of safety.

Why Are Future Cash Flows Discounted?

NPV uses discounted cash flows to account for the time value of money. As long as
interest rates are positive, a dollar today is worth more than a dollar tomorrow
because a dollar today can earn an extra day’s worth of interest. Even if future
returns can be projected with certainty, they must be discounted for the fact that
time must pass before they’re realized—time during which a comparable sum could
earn interest.

Is NPV or ROI More Important?

Both NPV and ROI (Return on Investment) are important, but they serve different
purposes. NPV provides a dollar amount that indicates the projected profitability
of an investment, considering the time value of money. ROI, on the other hand,
expresses the efficiency of an investment as a percentage, showing the return
relative to the investment cost. NPV is often preferred for capital budgeting
because it gives a direct measure of added value, while ROI is useful for comparing
the efficiency of multiple investments.
What Is the Difference Between NPV and ROI?
NPV calculates the difference between the present value of cash inflows and
outflows over a period of time, taking into account the time value of money. It
provides a dollar amount that indicates the profitability of an investment. ROI,
however, measures the efficiency of an investment by calculating the percentage
return relative to its cost. While NPV focuses on the absolute value created, ROI
highlights the relative performance of an investment.

What Happens to NPV When Interest Rate Increases?

When the interest rate increases, the discount rate used in the NPV calculation
also increases. This higher discount rate reduces the present value of future cash
inflows, leading to a lower NPV. As a result, projects or investments become less
attractive because their potential profitability appears diminished when evaluated
against a higher required rate of return.

Why Should you Choose a Project With a Higher NPV?

Choosing a project with a higher NPV is advisable because it indicates greater
profitability and value creation. A higher NPV means the projected cash inflows,
discounted to their present value, significantly exceed the initial investment and
associated costs. This suggests that the project is likely to generate more wealth,
enhancing the overall financial health and growth prospects of the business.
Ultimately, a higher NPV aligns with the goal of maximizing shareholder value.

ARTICLE SOURCES
Related Terms
Internal Rate of Return (IRR): Formula and Examples
The internal rate of return (IRR) is a metric used in capital budgeting to estimate
the return of potential investments. Here is the formula for calculating it. more
Rate of Return (RoR): Meaning, Formula, and Examples
A rate of return (RoR) is the gain or loss of an investment over a specified period
of time, expressed as a percentage of the investment’s cost. more
Payback Period: Definition, Formula, and Calculation
The payback period refers to the amount of time it takes to recover the cost of an
investment or how long it takes for an investor to hit breakeven. more
Discounted Payback Period: What It Is and How to Calculate It
The discounted payback period is a capital budgeting procedure used to determine
the profitability of a project. more
Profitability Index (PI): Definition, Components, and Formula
The profitability index (PI) is a technique used to measure a proposed project's
costs and benefits by dividing the projected capital inflow by the investment. more
Capital Budgeting: Definition, Methods, and Examples
Capital budgeting is a process that businesses use to evaluate the potential
profitability of new projects or investments. Here are three widely used methods.
more
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Net Present Value vs. Internal Rate of Return

Return on Investment vs. Internal Rate of Return: What's the Difference?

Internal Rate of Return (IRR)
Internal Rate of Return (IRR): Formula and Examples
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