Understanding NPV
As the name suggests, NPV is a net figure and is obtained as follows:
NPV = Present Value of all cash inflows – Present Value of all cash outflows
Usually, the outflow tends to be at the commencement of the project and is thus not discounted. However, where there is additional outflow some time in the future, this has to be discounted to its PV and added to the initial outflow before subtracting from the PV of cash inflows.
For investment decisions, if the NPV of a project is positive, then accept the project. If the NPV is negative, reject the project. The greater the NPV, the more financially rewarding the project.
The relationship between PV and FV is captured as follows:
Here, we have the following:
- FV = future value
- PV = present value
- K = discount rate
- n = number of years (assuming that now is year 0 and after one year is year 1)
Rearranging the equation, we get the following:
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