NPV in 2 Easy Steps

What you will learn

• What NPV actually measures, in plain English
• The NPV formula and what each symbol means
• Step 1: discount each cash flow back to today
• Step 2: add them up and subtract the upfront cost
• How to use NPV to accept or reject a project

The formulas

Worked example

A project costs $1,000 today and pays $400, $500 and $300 at the end of years 1, 2 and 3. The discount rate is 10%. What is the NPV?

1. Year 1: 400 ÷ 1.10 = 363.64
2. Year 2: 500 ÷ 1.10² = 413.22
3. Year 3: 300 ÷ 1.10³ = 225.39
4. Add them: 363.64 + 413.22 + 225.39 = 1,002.25
5. Subtract the cost: 1,002.25 − 1,000 = 2.25

Answer: NPV ≈ $2.25 (rounded to the cent). It is positive, so the project just clears the 10% required return and is acceptable.

Common questions

What is the formula for NPV?

NPV = Σ CFₜ ÷ (1 + r)ᵗ − C₀. Discount each future cash flow by (1 + r) raised to the year number, add up those present values, then subtract the initial investment C₀ paid today.

What does a positive NPV mean?

A positive NPV means the project's cash flows, in today's money, are worth more than it costs. It earns more than the discount rate, so it adds value and should be accepted. A negative NPV means it destroys value.

What discount rate should I use for NPV?

Use the project's required rate of return, which is often the company's cost of capital (WACC) for projects of normal risk. Riskier projects deserve a higher rate. In exams, the rate is usually given to you.

What is the difference between NPV and present value?

Present value converts one future amount into today's money. NPV does that for every cash flow in a project, adds them together, and nets off the upfront cost. NPV is basically many present values combined into one number.