Net present value (NPV)

Net Present Value, or NPV, is a key finance concept used in both the USA and the UK to assess if a project will add value to a business. NPV calculates the difference between the present value of future cash inflows and outflows. This involves estimating all future net cash flows and discounting them to present value using a rate that reflects the time value of money and project risk. When the total of these discounted flows exceeds the initial investment, the NPV is positive and the project is usually considered worthwhile. To calculate NPV, you start by forecasting all future net cash flows associated with a project. These cash flows are then discounted using a rate that reflects the required return, often known as the cost of capital, WACC, or simply the discount rate. A higher-risk project or company will typically use a higher discount rate. Sunk costs, or cash already spent, are excluded since only future flows matter. The NPV decision rule is straightforward: if a project’s NPV is positive, it’s expected to generate more value than it costs and should be pursued. If the NPV is negative, the project is likely to erode value and should be reconsidered or abandoned. While the math behind NPV is clear, real-life investment decisions require more nuance. NPV models assume a set stream of cash flows, but in reality, managers have choices throughout a project’s life—such as stopping a failing project early or