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Net present value (NPV) assesses the profitability of an investment on the basis that a dollar in the future isn’t worth the same as a dollar today.
NPV calculations are useful when you’re evaluating investment opportunities but the process is by no means perfect. It’s a useful starting point but it’s not a definitive metric that an investor can rely on for all investment decisions.
Key Takeaways
- Net present value (NPV) is a calculation that discounts a future stream of cash flows back into the present day.
- The NPV calculation helps investors decide how much they would be willing to pay today for a stream of cash flows in the future.
- A disadvantage of using NPV is that it can be challenging to accurately arrive at a discount rate that represents the investment’s true risk premium.
- Another disadvantage is that a company may select a cost of capital that’s either too high or too low leading it to miss a profitable opportunity.
Net Present Value (NPV)
Money loses value over time due to inflation but a dollar today can be invested and earn a return. Its future value could possibly be higher than a dollar received at the same point down the road.
NPV seeks to determine the present value of future cash flows of an investment above its initial cost. The discount rate element of the formula discounts the future cash flows to the present-day value. The investment is considered worthwhile if subtracting the initial cost of the investment from the sum of the cash flows in the present day is positive.
An investor could receive $100 today or a year from now. Most investors wouldn’t be willing to postpone receiving $100 today but what if they could choose to receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might be worthwhile unless another investment could yield a rate greater than 5% over the same period.
An investor would choose to receive $100 today, not $105 in a year with the 5% rate of return if they knew they could earn 8% from a relatively safe investment over the next year. The 8% is the discount rate in this case.
Important
An alternative to net present value (NPV) is the payback period or payback method. More attractive investments generally have shorter payback periods.
Disadvantages of Net Present Value (NPV)
There are some disadvantages to using the NPV calculation.
Selecting a discount rate
Accurately pegging a percentage number to an investment to represent its risk premium isn’t an exact science. If the investment is safe with a low risk of loss, 5% might be a reasonable discount rate to use. But what if the investment harbors enough risk to warrant a 10% discount rate? NPV calculations require the selection of a discount rate so they can be unreliable if the wrong rate is used.
The investment won’t have the same level of risk throughout its entire time horizon, either, and this makes matters even more complex.
Let’s go back to our example of a five-year investment. How should an investor calculate NPV if the investment had a high risk of loss for the first year but a relatively low risk for the last four years? The investor could apply different discount rates for each period but this would make the model even more complex and require the pegging of five discount rates.
Determining the cost of capital and cash flows
The cost of capital is the rate of return required to make an investment worthwhile. It helps determine whether the return on the investment is worth the risk.
A company must set an appropriate cost of capital when it decides whether to invest. It may determine that an investment isn’t worth the risk and miss and opportunity if it aims too high. It may be making investment decisions that aren’t worthwhile, however, if the cost of capital is too low.
It can be difficult to determine the cash flows from an investment when it doesn’t have a guaranteed return. This can sometimes be the case for companies that invest in new equipment or decisions that are based on business expansion. A company can estimate the kind of cash flows these investment decisions may have but there’s a chance they could be off by a significant percentage.
Investment size
A higher NPV doesn’t necessarily mean a better investment. The NPV will be higher for a project if there are two investments or projects up for decision and one project is larger in scale because NPV is reported in dollars. A larger outlay will therefore result in a larger number. It’s important to assess the returns from an investment in percentage terms to get an accurate picture of which investment provides a better return.
How Does Inflation Work?
Inflation involves a consistent escalation of prices, particularly for consumer goods, over an extended time. A $500 purchase in December 2024 might require $525 out of pocket in June 2025. It’s referred to as disinflation when increases pause. Deflation is a drop in prices that’s steady on ongoing like inflationary increases.
What Is a Payback Period?
The payback period is the amount of time it takes for an investor to reach the breakeven point and recover their initial investment cost.
How Is Cash Flow Measured?
Cash flow is the difference between money coming into a business or account and money leaving the business or account as it’s spent. The difference can be positive or negative. Negative cash flow isn’t sustainable indefinitely. Positive cash flow can be reduced by investments into growth or other opportunities.
The Bottom Line
Net present value calculates the value of future cash flow into the present day. It can be a tool for investors to help determine how much they’re willing to pay now for cash inflows in the future. Basing your investment decisions on NPV comes with some risks, however, particularly if you’re only considering this one factor. It can be tricky to calculate and can be affected and skewed by a company’s cost of capital.
Always seek expert help if you’re uncertain about an investment rather than rely too heavily on this metric.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.
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