05-03-2013, 03:28 PM
Net Present Value (NPV)
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NPV
A measure of discounted cash inflow to present cash outflow to determine whether a prospective investment will be profitable. For example, if a dentist wishes to purchase a new dental practice, he may calculate the net present value over a number of years to see if he will recover his investment in a reasonable period of time. If the ask price for the dental practice is $500,000, this is the present cash outflow used in the calculation. If the discounted cash inflow over, say, two years, is greater than or equal to $500,000, then the investment will likely be profitable.
What Does Net Present Value (NPV) Mean?
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project may yield.
Definition of Net Present Value (NPV)
Net present value (NPV) is one of two standard financial techniques used in discounted cash flow analysis (the other being internal rate of return (IRR)). To calculate NPV, the value of all future cash flows is discounted back to its present value (PV). If NPV is not positive, then the investment should be rejected. Discounting is done using a rate (the discount rate) that is determined by a number of factors including level of risk associated with the investment. While NPV calculates the total value of a discounted cash flow, its counterpart IRR calculates the annualized effective compounded return rate of the cash flows.
Advantages
Tells whether the investment will increase the firm's value
Considers all the cash flows
Considers the time value of money
Considers the risk of future cash flows (through the cost of capital)
Disadvantages
Requires an estimate of the cost of capital in order to calculate the net present value
Expressed in terms of dollars, not as a percentage