Glossary
Net Present Value (NPV)
Net present value (NPV) is the sum of an investment's future cash flows discounted to today at a required rate of return, minus the initial investment. A positive NPV means the investment is expected to earn more than the required return; a negative NPV means it is expected to earn less and would reduce value.
Formula
Example
A project costs $1,000,000 and returns $400,000 at the end of each of the next three years. At a 10% discount rate, the present values are $363,636, $330,579 and $300,526, totaling $994,741. NPV = $994,741 - $1,000,000 = -$5,259. Even though the project returns $1,200,000 in total, it falls slightly short of a 10% required return, so it would not meet that hurdle.
How it is used in underwriting
NPV is the most direct test of whether an investment creates value at a given cost of capital. Underwriters project cash flows, choose a discount rate that reflects the risk, often WACC for a company or a target return for an equity investment, and calculate NPV. Because NPV is measured in dollars, it shows how much value a project adds, which IRR does not. Corporate finance theory generally favors NPV when choosing between mutually exclusive projects, since IRR can rank projects incorrectly when they differ in size or timing.
NPV depends entirely on the discount rate and the cash flow forecast. A small increase in the discount rate can turn a positive NPV negative, so underwriters show NPV across a range of rates. Common mistakes include discounting levered cash flows at WACC (which double counts financing), ignoring terminal value or treating it carelessly, and using nominal cash flows with a real discount rate. In lending, NPV appears in loan workout analysis, where a lender compares the present value of a modified loan's payments with expected recovery from foreclosure, and in yield maintenance calculations.
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Frequently asked questions
What does a positive NPV mean?
A positive NPV means the present value of expected cash flows exceeds the cost of the investment when discounted at the required rate of return. In other words, the investment is expected to earn more than that required return and to add value. A zero NPV means it earns exactly the required return.
What is the difference between NPV and IRR?
NPV uses a chosen discount rate and gives a dollar amount of value created. IRR solves for the discount rate at which NPV equals zero and gives a percentage. NPV is better for comparing projects of different sizes, while IRR is easier to communicate as a rate of return.
What discount rate should be used for NPV?
Use a rate that reflects the risk of the cash flows. Companies often use their WACC for projects of average risk. Equity investors use their target return. Riskier cash flows require a higher rate. Showing NPV at several discount rates helps decision makers understand sensitivity.
Related terms
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