HKSM
Net Present Value (NPV)
A technique that computes the present net amount of future cash inflows and outflows by discounting them using an assumed interest or inflation rate, helping determine whether a project adds value today.
Key Points
- Uses an assumed interest or inflation (discount) rate to convert future cash flows into present values.
- Decision rule: accept projects with NPV greater than zero; when options are exclusive, choose the highest positive NPV.
- Captures the time value of money and can reflect risk through the chosen discount rate.
- Results depend on assumptions about cash flow size, timing, and discount rate; sensitivity analysis is recommended.
Example
A project needs an initial investment of $100,000 and is expected to return $60,000 in year 1 and $60,000 in year 2. Using a 10% discount rate (assumed interest), PV of benefits is $60,000/1.10 + $60,000/1.10^2 = $54,545 + $49,587 = $104,132. NPV = $104,132 - $100,000 = $4,132. Because NPV is positive, the project adds value.
PMP Example Question
Which statement best describes how Net Present Value (NPV) should be used in project selection?
- NPV discounts future cash flows at an assumed rate and favors the option with the greatest positive NPV.
- NPV ignores the time value of money and focuses on how quickly costs are recovered.
- NPV is identical to IRR and always yields the same ranking.
- NPV cannot compare mutually exclusive projects because it is not a monetary measure.
Correct Answer: A — NPV discounts future cash flows and selects the highest positive NPV
Explanation: NPV converts future cash flows to present value using an assumed discount rate (interest or inflation) and the preferred choice is the alternative with the largest positive NPV.
