TheInfoList

The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the
time value of money The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, ...
. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
Time value of money The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, ...

# Common pitfalls

* If, for example, the ''R''''t'' are generally negative late in the project (''e.g.'', an industrial or mining project might have clean-up and restoration costs), then at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculate the cost of financing such losses. * Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, ''e.g.'', by actuarial or
Monte Carlo Monte Carlo (; ; french: Monte-Carlo , or colloquially ''Monte-Carl'' ; lij, label= Monégasque, Munte Carlu; ) is officially an administrative area of the Principality of Monaco Monaco (; ), officially the Principality of Monaco (french: ...
techniques, and explicitly calculating the cost of financing any losses incurred. * Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the
risk-free rate The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payment(s) over a fixed period of time that is assumed to meet all payment obligations. Since the risk-free ...
as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The
certainty equivalent For an individual, a risk premium is the minimum amount of money by which the expected return on a risky asset (such as stock) must exceed the known return on a Risk-free bond, risk-free asset (such as a Treasury bond) in order to induce an individ ...
model can be used to account for the risk premium without compounding its effect on present value. * Another issue with relying on NPV is that it does not provide an overall picture of the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, usually,
Internal rate of return Internal rate of return (IRR) is a method of calculating an investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, ...
or other efficiency measures are used as a complement to NPV. * Non-specialist users frequently make the error of computing NPV based on cash flows after interest. This is wrong because it double counts the time value of money. Free cash flow should be used as the basis for NPV computations.

# History

Net present value as a valuation methodology dates at least to the 19th century.
Karl Marx Karl Heinrich Marx (; 5 May 1818 – 14 March 1883) was a German philosopher A philosopher is someone who practices philosophy Philosophy (from , ) is the study of general and fundamental questions, such as those about reason, M ...

refers to NPV as
fictitious capital Fictitious capital (German: ''fiktives Kapital'') is a concept used by Karl Marx in his critique of political economy. It is introduced in chapter 25 of the Capital, Volume III, third volume of Capital. Fictitious capital contrasts with what Mar ...
, and the calculation as "capitalising," writing: In
mainstream The mainstream is the prevalent current thought In their most common sense, the terms thought and thinking refer to conscious cognitive processes that can happen independently of sensory stimulation. Their most paradigmatic forms are judging, r ...
neo-classical economics Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are driven by the supply and demand In microeconomics Microeconomics is a branch of that studies ...
, NPV was formalized and popularized by
Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist An economist is a professional and practitioner in the social science Social science is the branch The branches and leaves of a tree. A branch ( or , ...

, in his 1907 ''The Rate of Interest'' and became included in textbooks from the 1950s onwards, starting in finance texts.

# Alternative capital budgeting methods

*
Adjusted present value Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers. The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value In economics Economics ...
(APV): adjusted present value, is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing. *
Accounting rate of return Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been called the "language ...
(ARR): a ratio similar to IRR and MIRR * Cost-benefit analysis: which includes issues other than cash, such as time savings. *
Internal rate of return Internal rate of return (IRR) is a method of calculating an investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, ...
(IRR): which calculates the rate of return of a project while disregarding the absolute amount of money to be gained. * Modified internal rate of return (MIRR): similar to IRR, but it makes explicit assumptions about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return. *
Payback period Payback period in capital budgeting refers to the time required to Recoupment, recoup the funds expended in an investment, or to reach the Break-even (economics), break-even point. Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibst ...
: which measures the time required for the cash inflows to equal the original outlay. It measures risk, not return. *
Real option Real options valuation, also often termed real options analysis,Adam Borison (Stanford University)''Real Options Analysis: Where are the Emperor's Clothes?'' (ROV or ROA) applies option (finance), option Valuation of options, valuation techniques ...
: which attempts to value managerial flexibility that is assumed away in NPV. * Equivalent annual cost (EAC): a capital budgeting technique that is useful in comparing two or more projects with different lifespans.