The short video below explains the concept of net present value and illustrates how it is calculated. The study note below also explains NPV further.

NPV recognises that there is a difference in the value of money over time.

Offered the choice of £100 now or £100 in one year's time, most rationale people would opt to receive the £100 now. Why? Because you could invest the £100 in a savings account and get interest on the investment. In one year your £100 might have turned into £105, so why choose to wait for £100 next year?

What we are describing above is the opportunity cost of money (sometimes also referred to as the "time value of money").

NPV calculations reflect the time value of money by "discounting" (i.e. reducing) the value of future cash flows. In effect, cash flows received earlier in an investment project are considered to be worth more than those who are expected several years ahead.

A question that often arises is – what percentage (or "rate") should be used to discount future cash flows?

One answer would be to use the interest rate which could be obtained on saving.

A more common approach is to consider what the required rate of return is for shareholders – this takes into account the risk they perceive when investing in the business.

In the example project below, the required return for shareholders is 10%. That means that in Year 1 (one years' time) a cash flow would be discounted by 10% to calculate the value of the cash flow now to shareholders.

You can see from the table that the £100,000 net cash flow in Year 2 is discounted to a present value of £83,000 in the calculation. In contrast, the initial investment of £500,000 has no discounting applied, because the cash outflow arises now – at the start of the project.

NPV looks at the total cash flows of the project. In this example, the project is only expected to generate returns over five years. Applying discount factors to each year, the total net present value of the project is £405,000 (positive).

• A positive NPV for a project suggests that the investment project should go ahead.
• A negative NPV would suggest that a project should be rejected

The main advantages and disadvantages of using NPV as a method of investment appraisal are as follows:

Advantages of using NPV

Takes account of time value of money, placing emphasis on earlier cash flows

Looks at all the cash flows involved through the life of the project

Use of discounting reduces the impact of long-term, less likely cash flows

Has a decision-making mechanism – reject projects with negative NPV

Disadvantages of using NPV

More complicated method – users may find it hard to understand

Difficult to select the most appropriate discount rate – may lead to good projects being rejected

The NPV calculation is very sensitive to the initial investment cost