Net present value (NPV) represents the amount by which the expected cash flows of an investment exceeds the initial amount invested. Net present value is calculated using the formula of NPV= ∑ {Period Cash Flow / (1+R)^T} - Initial Investment, where R represents the interest rate and T represents the number of time periods. Because the formula accounts for the time value of money and investors may apply their choice of discount rate, NPV is frequently used investment metric used to compare investments with different initial capital outlays, holding periods or cash flow patterns.
For example, if investment A requires a $200,000 initial investment and is expected to generate even cash flows of $80,000 for 3 years while investment B also requires a $200,000 investment but is expected to return cash flows over three years of $10,000, $20,000 and $225,000. If the investor applies an 8.0% discount rate, then investment A produces an NPV of $6,168 (($80,000/(1+.08)^1)+($80,000/(1+.08)^2)+($80,000/(1+.08)^3) - $200,000) while investment B yields a net present value of $5,018 (($10,000/(1+.08)^1)+($20,000/(1+.08)^2)+($225,000/(1+.08)^3)-$200,000). Note that investment B has higher expected total cash flows but a lower NPV - this is due to the time value of money concept. In deciding among investment options, if the investor has unlimited capital, then both options would be viable as both produce positive NPV values when applying the investor’s required discount rate. However, if the investor has limited capital and can only invest in one of the options, then investment A would likely be their choice as it produces the higher NPV between the two options. However, as is the case with internal rate of return (IRR), the net present value calculation has its limitations, such as applying a constant discount rate over an investment’s expected holding period when cash flows may not be of equal risk. As such, NPV tends to be one of multiple financial metrics used to evaluate potential investments.