Finance term
Net Present Value (NPV)
Also known as: NPV, net present value
Definition
Net Present Value (NPV) is the present-value sum of all expected cash flows from an investment minus the initial cost. NPV > 0 means the investment creates value; NPV < 0 means it destroys value.
Detailed explanation
NPV discounts future cash flows back to today's dollars using the cost of capital as the discount rate, then subtracts the initial investment. Formula: NPV = Σ [CFt / (1 + r)^t] − Initial Investment, where CFt is cash flow in period t and r is the discount rate (cost of capital).
The NPV rule is foundational in capital budgeting: invest if NPV > 0 (the project returns more than the cost of capital), decline if NPV < 0. Unlike IRR, NPV gives an absolute dollar value-added estimate, not just a rate — which makes it easier to compare mutually exclusive projects of different sizes.
For small business owners considering financing, NPV analysis clarifies the value proposition of borrowing. A $50,000 equipment loan at 9% generates positive NPV if the equipment's incremental cash flows exceed the loan's present cost — including interest and principal repayment. Running a quick NPV estimate before committing to financing disciplines the investment decision.
NPV and IRR together: when IRR > discount rate, NPV > 0. For a single conventional project (negative up front, positive thereafter), both methods give the same accept/reject decision. NPV is preferred when comparing mutually exclusive investments because it measures value added in dollars, not percentages.
◈ Worked example
- $50K equipment investment, $15K/year for 5 years, 10% discount rate: NPV = $15K × 3.791 (PV annuity factor) − $50K = $56,865 − $50,000 = +$6,865 — invest
- Same investment at 20% discount rate: $15K × 2.991 − $50K = $44,865 − $50,000 = −$5,135 — decline
- MCA cost NPV analysis: does the additional revenue enabled by $50K advance, discounted at your hurdle rate, exceed $65K total payback? If yes, NPV positive — use it. If no, find cheaper capital.
Common questions
The most-asked questions about Net Present Value (NPV) — answered straightforwardly.
What discount rate should I use for NPV? +
Your business's cost of capital (WACC) is the theoretically correct discount rate. For most small businesses without a formal WACC calculation, use the rate you'd pay for new financing (e.g., 9% for a bank loan) as a practical floor. If you're risk-adjusting for a particularly speculative investment, add a risk premium on top.
What's the difference between NPV and payback period? +
Payback period simply counts years until you recover the initial investment — it ignores time value of money and ignores any returns after payback. NPV accounts for both timing and the discount rate, giving a more accurate measure of true value added. Payback is intuitive and quick; NPV is rigorous. Use both.
If NPV is positive, should I always borrow to fund the investment? +
NPV > 0 means the investment is expected to create value at your discount rate. Whether to fund it with debt depends on whether the all-in cost of debt (interest + fees + PG risk) still leaves NPV positive after financing costs. Run the NPV with the actual financing cost as your discount rate, not just the investment return in isolation.
Further reading
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