Net Present Value (NPV)

Net Present Value (NPV) is a method used in capital budgeting to analyze the profitability of an investment or project. NPV computes the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Formula

The formula for NPV is:

N P V = \sum \frac{C F_{t}}{(1 + r)^{t}} - C_{0}

Components

\begin{aligned} C F_{t} : Cash inflow (or outflow) during time period t \\ r : Discount rate, often considered the opportunity cost or required rate of return \\ t : Time period \\ C_{0} : Initial investment at the beginning (time 0) \end{aligned}

Strengths

Considers the time value of money, making it more accurate for long-term projects.
Can be used to compare different investment opportunities and select the most profitable ones.
Helps in assessing the absolute profitability of an investment.

Limitations

Requires estimates of future cash flows, which can be uncertain.
The choice of the appropriate discount rate can be subjective.

Example

Assuming a project requires an initial investment of $100,000 and is expected to return $50,000 for three years. If we take a discount rate of 10%, the NPV can be calculated by discounting each of the future cash flows back to the present and then subtracting the initial investment.

Using the formula, we can determine if the project's returns justify the initial investment.

Net Present Value (NPV) ​

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