net present value

= NPV

A method of capital budgeting in which the value of an investment is calculated as the total present value of all cash inflows, cash outflows minus the cost of the initial investment. If the net present value is positive the investment should be considered. A negative net present value indicates that the investment should be rejected. See also discounted cash flow.

Example

A company is considering the purchase of a new computer system, which is expected to save £100,000 in cash operating costs each year. Its estimated useful life (how long it will last) is five years, at the end of which it will have no net residual value.

The cash flows for the project are as follows. A simple analysis shows that the savings over five years are £500,000 (5 × £100,000) and the cost is £390,000, which gives a surplus of £110,000 (£500,000 – £390,000). However, such an analysis ignores the time value of money: £1 received in the future is not equal to £1 received today. To calculate the present value of future cash flows it is necessary to calculate the discount factor.

Assuming that the cost of capital for the project is 8%, the discount factor is calculated as follows:

(An alternative to calculating the discount factor in this way is the use of present value tables or spreadsheet routines.)

The net present value can then be calculated:

In this case, the net present value is positive and therefore it could be argued that managers should buy the new computer system. However, £9300 is quite a small amount and managers may not be confident that the savings will be the supposed £100,000 a year. Also, the new computer system may not last five years. The net present value calculation is very important as it highlights that this is a marginal decision.