Net present value is an analysis tool used to decide whether to invest in a capital asset. It is employed as part of the capital budgeting process. A desirable investment is one that yields a positive net present value, which implies that a business will receive excess cash over time as a result of the investment. A negative net present value indicates that a company will lose money on a proposed investment. A negative net present value is usually grounds to terminate an investment that is under consideration.
Net present value is calculated as the difference between the present value of one or more inbound cash flows and one or more outbound cash flows. The discounted cash flow methodology is used to derive present value, using a discount rate as the basis for the discounting. The discount rate is typically based on the cost of capital of the business running the analysis. If the cash flows associated with a proposed investment are expected to be unusually risky, then the discount rate may be increased, thereby reducing the net present value of the associated cash flows.
Net present value is not a perfect analysis tool, for it suffers from the following problems:
- Estimated cash flows rarely match actual results, especially when the original estimates are excessively optimistic.
- The discount rate used for a capital asset analysis may not be appropriate, given the incremental cost of the capital required to fund a project.
- An adjustment of the discount rate to account for risk is usually a guess; there is no quantitative derivation of the adjustment.
- An investment based on a net present value analysis only looks at the circumstances of a specific investment, rather than the entire system of profit generation; thus, investments using NPV can be sub-optimized.