Net present value
Net present value is the worth of an investment today, found by discounting its future cash flows and subtracting the initial outlay.
To know whether an investment is worth making, you reduce all its future cash flows to today's money and ask whether they exceed the cost. That figure is net present value.
Net present value is the value of an investment today, calculated by discounting all its expected future cash flows to the present and subtracting the initial outlay. It is the central tool of investment appraisal, and the soundest single rule for deciding whether a project creates or destroys value.
Future cash flows in today's money
The logic rests on the time value of money. A project produces cash flows spread over future years, but money in the future is worth less than money now, so the future cash flows must each be discounted back to present value before they can be compared with the cost incurred today. Adding up these discounted future inflows and subtracting the initial investment gives the net present value: the amount by which the project is expected to increase wealth, expressed in today's money.
The decision rule
The rule is simple and powerful: accept a project if its net present value is positive, reject it if negative. A positive value means the discounted future returns exceed the cost, so the project creates value; a negative value means it destroys value, returning less than the cost of the capital tied up. Among competing projects, the one with the highest net present value adds the most wealth. This makes net present value the benchmark against which other appraisal methods are judged, because it directly measures value created.
The pivotal discount rate
The result hinges on the discount rate chosen, which represents the return required given the risk and the cost of capital. A higher discount rate shrinks distant cash flows more severely, lowering the net present value and favouring projects that pay off sooner; a lower rate does the reverse. Because the rate so strongly shapes the answer, and because future cash flows are themselves uncertain estimates, net present value is only as reliable as its inputs, and a precise-looking figure can rest on shaky assumptions.
Net present value is the gold standard of investment appraisal, the rule that asks directly whether a project will add to wealth once the timing and cost of capital are accounted for. Its discipline, discounting future cash flows to a common present and comparing them with the cost, is the core of sound financial decision-making, even as its dependence on uncertain forecasts and a chosen discount rate demands that its tidy numbers be treated with appropriate caution.