Net present value (NPV) is the value of a project's future cash flows in today's money, after discounting at the cost of capital and subtracting the initial investment. If NPV is positive, the project adds value and should be accepted. Example: a £1,000 project returning £400, £500 and £600 at a 10% cost of capital has an NPV of £227.65.
The NPV formula and decision rule
NPV = Σ [Cash flowt ÷ (1 + r)t] − initial investment, where r is the cost of capital and t the year.
- NPV positive: accept. The project earns more than investors require.
- NPV zero: it earns exactly the required return (this rate is the IRR).
- NPV negative: reject on financial grounds.
Worked example
A project costs £1,000 and returns £400, £500 and £600 over three years. The cost of capital is 10%.
| Year | Cash flow (£) | Discount factor at 10% | Present value (£) |
|---|---|---|---|
| 0 | (1,000) | 1.000 | (1,000.00) |
| 1 | 400 | 0.909 | 363.64 |
| 2 | 500 | 0.826 | 413.22 |
| 3 | 600 | 0.751 | 450.79 |
| NPV | 227.65 |
The NPV is positive, so the project should go ahead: it increases the organisation's value by about £228 in today's money.
Other investment appraisal methods
The book's Chapter 18 compares four methods. Using the same project:
| Method | Result for the example | Best for | Weakness |
|---|---|---|---|
| NPV | £227.65 | Long-term projects where the cost of capital is known; shows the effect on shareholder wealth | Needs a reliable cost of capital |
| IRR | About 21.7% | When the cost of capital is uncertain: shows the highest it could be | Can rank projects wrongly |
| Payback | 2.17 years (£900 back after 2 years, then £100 of £600 in year 3) | Short-term projects or when cash is tight | Ignores cash after payback and the time value of money (unless discounted) |
| Accounting rate of return | 16.7% (average profit £166.67 after straight-line depreciation of £333.33 a year, ÷ £1,000) | Comparing with profit-based targets | Uses profit, not cash; can be manipulated |
Good practice is to use more than one method and to consider non-financial factors too.
Advantages and limitations of NPV
Advantages
- Uses the time value of money and all cash flows
- Gives an absolute money figure: the value added
- Consistent with maximising shareholder wealth
Limitations
- Depends on forecasts and the chosen discount rate
- Harder for non-finance managers to understand than payback
- Ignores non-financial and strategic benefits unless added separately
NPV in ACCA SBL
You may need to interpret or challenge NPV figures in an exhibit. Ask: are the cash flow forecasts realistic? Is the discount rate right for the risk? What happens if sales are 10% lower (sensitivity)? Then weigh the result against strategic fit and stakeholder impact before recommending.
FAQs
What is NPV?
Net present value is the present value of a project's future cash inflows minus the present value of its outflows, discounted at the cost of capital. A positive NPV means the project adds value.
What is the NPV formula?
NPV = sum of [cash flow in year t ÷ (1 + r) to the power t] minus the initial investment, where r is the cost of capital.
Is a negative NPV bad?
Yes, financially: the project returns less than the cost of capital and would reduce shareholder wealth. It may still be chosen for strategic, legal or ethical reasons, which should be stated.
What is the Excel NPV trap?
Excel's =NPV function assumes the first cash flow is at the end of year 1. Leave the year 0 investment out of the range and add it separately: =NPV(rate, year1:yearN) + year0.
NPV vs IRR: which is better?
NPV, because it measures the money value added at the actual cost of capital. IRR is a useful percentage but can rank projects wrongly.