NET PRESENT VALUE Meaning and
Definition
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Net present value (NPV) refers to a financial metric used primarily in investment analysis to determine the profitability of a project or investment. It measures the difference between the present value of cash inflows and the present value of cash outflows over a specified time period, taking into account the time value of money.
To calculate the net present value, the estimated future cash flows stemming from the investment are discounted back to their present value using a predetermined discount rate. The discount rate is usually the cost of capital, representing the rate of return required by investors to undertake the investment. The resulting present value of the cash inflows is then subtracted from the present value of the cash outflows.
A positive net present value signifies that the investment is expected to generate more cash inflows than outflows, indicating that it is potentially profitable. Conversely, a negative NPV suggests that the investment is likely to result in a loss.
Net present value serves as a useful tool to make investment decisions by comparing the potential profitability of different investment opportunities. It enables investors to assess whether a project is expected to generate a return greater or lesser than the cost of capital. In general, investments with a positive NPV are considered favorable, while those with a negative NPV are typically avoided.
