NPV Formula

Calculating net present value involves calculating the cash flows for each period of the investment
or project, discounting them to present value, and subtracting the initial investment from the sum
of the project’s discounted cash flows.

The formula for NPV is:

In this formula:

Cash Flow is the sum of money spent and money earned on the investment or project for a given
period of time.
n is the number of periods of time.
r is the discount rate.
Components of NPV
Cash Flow
Cash flows are any money spent or earned for the sake of the investment, including things like
capital expenditures, interest, and loan payments. Each period’s cash flow includes both outflows
for expenses and inflows for profits, revenue, or dividends.

Number of Periods (n)

The number of periods equals how many months or years the project or investment will last.
Sometimes, the number of periods will default to 10, or 10 years, since that is the average lifespan
of a business. However, different projects, companies, and investments may have more explicit
timeframes.

Discount Rate (r)

In most situations, the discount rate is the company’s weighted average cost of capital (WACC). A
company’s WACC is how much money it needs to make to justify the cost of operating and
includes things like the company’s interest rate, loan payments, and dividend payments.

Cash flows need to be discounted because of a concept called the time value of money. This
concept is the belief that money today is worth more than money received at a later date. For
example, $10 today is worth more than $10 a year from now because you can invest the money
received now to earn interest over that year. Additionally, interest rates and inflation affect how
much $1 is worth, so discounting future cash flows to the present value allows us to analyze and
compare investment options more accurately.

Initial Investment
The initial investment is how much the project or investment costs upfront. For example, if a
project costs $5 million at the start, that should be subtracted from the total discounted cash flows.