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What is NPV or Net Present Value?
NPV or Net Present Value is a financial metric in capital budgeting that is used to evaluate whether a project or an investment is going to yield a good return in the future or not. It can be simply represented as the difference between the present value of cash inflows and the present value of cash outflows. In the long run, a positive NPV value indicates good potential return over investment, while the negative NPV value means that the investment is likely to lose money. Sometimes NPV is also referred to as NPW or Net Present Worth.
NPV is useful in capital budgeting for analyzing the profitability of project investment. It also aids in assessing the return of interest. Project or investment with a higher NPV, is profitable while negative NPV results in a loss. NPV generally has practical uses in everyday life. It is a common metric used in financial analysis and accounting.
Here’s the Net Present Value NPV formula (when cash arrivals are even):
NPVt=1 to T = ∑ Xt/(1 + R)t – Xo
Xt = total cash inflow for period t
Xo = net initial investment expenditures
R = discount rate, finally
t = total time period count
The NPV formula (when cash arrivals are uneven):
NPV = [Ci1/ (1+r)1 + Ci2/(1+r)2 + Ci3/(1+r)3 + …] – Xo
R is the specified return rate per period;
Ci1 is the consolidated cash arrival during the first period;
Ci2 is the consolidated cash arrival during the second period;
Ci3 is the consolidated cash arrival during the third period, etc…
Use of NPV Formula
By using this NPV formula, the investors find out the difference between the cash inflows from the investments and the cost of investments.
If the difference is positive, it’s a great project. If the difference is negative, it’s not worthy for the investors.
It is used for making prudent business decisions for the following reasons –
First of all, NPV formula is very easy to calculate. Before making any decisions regarding investments, if you know how to calculate NPV; you will be able to make better decisions.
Secondly, it compares the present value of both cash inflow and cash outflow. As a result, the comparison provides the right perspective for the investors to make the right decision.
Thirdly, NPV offers you a conclusive decision. After calculating this, you will directly get to know whether to go for the investments or not.
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