Net Present Value (NPV)

Money received in the future is worth less than money today, because today's money could be invested. NPV handles this by discounting each future cash flow back to its present value using a discount rate, usually the company's cost of capital. These present values are added up and the initial cost is subtracted.

Suppose a machine costs 50,000 today and is expected to bring in 15,000, 18,000, 20,000 and 12,000 over the next four years. Discounted at 8% a year, those cash flows are worth about 54,018 today. Subtracting the 50,000 cost gives an NPV of about 4,018.

A positive NPV means the project is expected to earn more than the 8% required return and add value. An NPV of zero means it earns exactly 8%. A negative NPV means it earns less than investors require, so it would destroy value.

NPV is widely considered the most reliable investment rule, because it accounts for the timing and size of cash flows and measures value in money terms. Its weakness is that it depends on forecasts and on the discount rate, both of which can be uncertain.