Net Present Value
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Insights on the Net Present Value Calculation
What Is Net Present Value?
The NPV formula strives to pull all future cash flow values to what each cash flow is worth today. Then, the NPV formula compares the value of those cash inflows against the initial investment or cash outflow. If the NPV of a project is positive (discounted future cash flow is greater than the initial investment), a project is expected to be profitable.
What Is Net Present Value Used For?
WACC is a formula that gives insight into how much interest a company owes for each dollar it finances. Analysts use WACC to assess the value of an investment. WACC is a key number used in discounted cash flow (DCF) analysis. Company management also uses WACC figures as a hurdle rate when choosing which projects to undertake.
What Is the WACC Used for?
Net present value (NPV) is used in capital budgeting to determine whether a project will be profitable, or to evaluate different projects and determine which one will be the most profitable.
How Is NPV Calculated?
NPV is calculated by taking the present value of all cash flows over the life of a project. Then, the present value of cash flows is subtracted from the investment's initial investment. If the difference is positive (greater than 0), the project will be profitable.
What Are the Main Drawbacks of NPV?
NPV needs accurate assumptions for a number of variables like initial costs and future cash flows—and, most importantly, the discount rate or cost of capital. As small changes in the discount rate can lead to significant swings in the discounted value of future cash flows, inaccurate discount rates may lead to incorrect NPV and hence an erroneous decision on the project’s profitability and viability.
What Does a Negative NPV Number Mean?
A negative NPV number means that a project will be unprofitable as the initial startup costs exceed the discounted value of net future cash flows.
