How is net present value (NPV) calculated?

Net present value (NPV) is a financial metric used to evaluate the attractiveness of an investment or project. It is calculated by discounting the expected future cash flows from the investment back to their present value using a specific discount rate, and then subtracting the initial investment cost.

The rationale behind this method is that money has a time value; a dollar received today is worth more than a dollar received in the future due to its potential earning capacity. By applying a discount rate to future cash flows, the NPV accounts for this time value, enabling investors to assess whether the future returns outweigh the initial costs.

In this calculation, if the NPV is greater than zero, it typically indicates that the projected earnings (adjusted for time value) exceed the initial investment, making the investment financially viable. Conversely, an NPV less than zero would suggest the investment might not be worth pursuing.

Other approaches mentioned in the options, such as simply subtracting future cash inflows from cash outflows, determining total cash flow, or calculating average cash flow, do not incorporate the time value of money and therefore do not provide a complete picture of an investment’s profitability.