Net Present Value (NPV) Definition

Question

How does Net Present Value work?

Answer

Net Present Value is a way to measure cash flows that provides a more accurate representation of the value of money. It discounts future cash flow receipts by using a ‘discount factor’ which reduces the value the further into the future it will be received. By summing the discounted values of receipts, and by deducting any outlays, a Net Value is produced that can be used to assess the value of an investment or project. If the Net Present Value is positive, it means the cash flows are profitable, taking into consideration the time value of money. Time value of money is the concept that money promised or due in the future is worth less than money now. This is due to a few factors - one is interest/earnings. Money gained now could be invested and gain interest or profits, money not yet received cannot. Another consideration is that a fixed cash receipt will become less valuable in real terms as inflation decreases its nominal value - £1 in 1920 was a considerable amount, but if the same person received it in 1980 it would be worth far less. Another factor is the uncertainty involved in future receipts, situations could change before they are achieved.

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