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.
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.
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.
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.
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.