NPV, or net present value, is how much an investment is worth throughout its lifetime, discounted to today’s value. The formula for NPV is often used in investment banking and accounting to determine if an investment, project, or business will be profitable in the long run.
In this guide, we’ll go over:
- What Is NPV?
- NPV Formula
- Net Present Value Drawbacks
- Showing NPV Calculation Skills on Your Resume
- Related Finance Skills
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What Is NPV?
Net present value is used to determine whether or not an investment, project, or business will be profitable down the line. Essentially, the NPV of an investment is the sum of all future cash flows over the investment’s lifetime, discounted to the present value.
Calculating net present value is often used in budgeting to help companies decide how and where to allocate capital. By bringing each investment option or potential project down to the same level — how much it will be worth in the end — finance professionals are better equipped to make strategic decisions.
To calculate NPV, you have to start with a discounted cash flow (DCF) valuation. NPV is the end result of a DCF valuation. You can learn how to calculate DCFs with JPMorgan Chase’s Investment Banking Virtual Experience Program.
Who Uses Net Present Value?
NPV is used primarily in corporate finance. For example, investment bankers may compare net present values to determine which merger or acquisition is worth the investment. Additionally, some accountants, such as certified management accountants, may rely on NPV when handling budgets and prioritizing projects.
Business owners can also benefit from understanding how to calculate NPV to help with budgeting decisions and to have a clearer view of their business’s value in the future.
>>MORE: Learn if finance is a good career path for you.
Calculating net present value involves calculating the cash flows for each period of the investment or project, discounting them to present value, and subtracting the initial investment from the sum of the project’s discounted cash flows.
The formula for NPV is:
In this formula:
- Cash Flow is the sum of money spent and money earned on the investment or project for a given period of time.
- n is the number of periods of time.
- r is the discount rate.
Components of NPV
Cash flows are any money spent or earned for the sake of the investment, including things like capital expenditures, interest, and loan payments. Each period’s cash flow includes both outflows for expenses and inflows for profits, revenue, or dividends.
Number of Periods (n)
The number of periods equals how many months or years the project or investment will last. Sometimes, the number of periods will default to 10, or 10 years, since that is the average lifespan of a business. However, different projects, companies, and investments may have more explicit timeframes.
Discount Rate (r)
In most situations, the discount rate is the company’s weighted average cost of capital (WACC). A company’s WACC is how much money it needs to make to justify the cost of operating and includes things like the company’s interest rate, loan payments, and dividend payments.
Cash flows need to be discounted because of a concept called the time value of money. This concept is the belief that money today is worth more than money received at a later date. For example, $10 today is worth more than $10 a year from now because you can invest the money received now to earn interest over that year. Additionally, interest rates and inflation affect how much $1 is worth, so discounting future cash flows to the present value allows us to analyze and compare investment options more accurately.
The initial investment is how much the project or investment costs upfront. For example, if a project costs $5 million at the start, that should be subtracted from the total discounted cash flows.
Interpreting Net Present Value
Net present value has three potential outcomes:
- Positive NPV: A positive result from an NPV calculation means the project or investment may be profitable and worth pursuing.
- Negative NPV: A negative result from an NPV calculation means the project or investment is unlikely to be profitable and should probably not be pursued.
- Zero NPV: An NPV of zero means the project or investment is neither profitable nor costly. A company may still consider projects and investments with an NPV of zero if the project has significant intangible benefits, such as strategic positioning, brand equity, or increased consumer satisfaction.
>>MORE: See how to calculate NPV for one of the top investment banks with Bank of America’s Investment Banking Virtual Experience Program.
Net Present Value Example
Let’s assume your company has two potential projects it can start. How can we decide which project is the better option?
Your company’s weighted average cost of capital is 7%, so 7% will be the discount rate for both projects. Each project lasts five years. The initial investment and cash flows for the two projects are:
- Initial investment: $15 million
- Cash Flow Year 1: $3 million
- Cash Flow Year 2: $3 million
- Cash Flow Year 3: $5 million
- Cash Flow Year 4: $5 million
- Cash Flow Year 5: $5 million
- Initial investment: $20 million
- Cash Flow Year 1: $2 million
- Cash Flow Year 2: $4 million
- Cash Flow Year 3: $6 million
- Cash Flow Year 4: $8 million
- Cash Flow Year 5: $10 million
Discounting these cash flows using the 7% weighted average cost of capital, the annual discounted cash flows for each project are:
|Year||Project A||Project B|
|Cash Flow Sum||$16,884,950||$23,493,725|
Once we have the total of the discounted cash flows for the duration of the project, we can find the net present value for each by subtracting the initial investment:
Project A’s NPV = $16,884,950 – $15,000,000
NPV = $1,884,950
Project B’s NPV = $23,493,725 – $20,000,000
NPV = $3,493,725
Either project will be profitable. At face value, it’s easy to assume Project B would be better because it has a higher NPV, meaning it’s more profitable. However, it’s important to consider other factors. For example, is the NPV of Project B high enough to warrant a bigger initial investment? Financial professionals should consider intangible benefits, such as strategic positioning and brand equity, to determine which project is a better investment.
>>MORE: Although it’s possible to calculate NPV by hand, most finance professionals rely on Excel. Learn the basics you need for a finance career with JPMorgan’s Excel Virtual Experience Program.
Net Present Value Drawbacks
As we saw in the previous example, a positive NPV does not describe the initial investment cost and may not be enough to determine if an investment is worthwhile. For example, let’s say one project has an NPV of $15 and another has an NPV of $200. The $200 project seems more worthwhile, but what if the initial investment for the $15 project was only $1, and the initial investment for the $200 project was $150?
Another flaw with relying only on net present value is that the formula uses only estimates. Especially with very long-term investments, these estimates may not always be accurate. Additionally, the formula does not account for external benefits from certain investments or projects. Intangible benefits may not be able to be recorded on a balance sheet, but that does not mean they’re not valuable.
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Showing NPV Calculation Skills on Your Resume
Calculating and interpreting NPV for projects, investments, and businesses is one part of two broad skill categories: financial modeling and business valuation. On your resume, you could include NPV as an example of your skills in modeling or valuation.
Additionally, if you have prior work or internship experience using NPV, you can call that out in the description of the job or internship. For example, you can mention a project that involved calculating the net present value to compare five investment options as an intern with Goldman Sachs.
If you don’t have any internship or work experience using NPV, your cover letter is a great place to show off your hard skills. You can discuss your personal experiences using financial modeling or business valuation tactics. For example, you can talk about a time you helped a friend calculate the net present value of an investment they were considering or when you helped a family member determine the value of their small business.
Related Finance Skills
Understanding how to calculate and interpret net present value is a core skill for many careers in finance. Other crucial skills for finance professionals include:
- Calculating the weighted average cost of capital (WACC)
- Understanding the uses and limitations of EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Having a familiarity with corporate finance concepts, like stock options
- Knowing how to complete a comparable company analysis
Explore these skills and more with Forage’s finance and accounting virtual experience programs.
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