How is net present value (NPV) determined?

Net present value (NPV) is a fundamental concept in finance used to evaluate the profitability of an investment. It is determined by taking the future cash inflows generated by the investment, discounting them back to their present value using a specific discount rate (often the cost of capital), and then subtracting the initial investment cost from this present value.

This method is crucial as it accounts for the time value of money, reflecting the principle that a dollar today is worth more than a dollar in the future due to its potential earning capacity. By focusing on the difference between the present value of cash inflows and the initial investment, NPV provides a clear measure of how much value an investment is expected to create or destroy. A positive NPV indicates that the projected earnings (adjusted for time and risk) exceed the initial costs, making it a desirable investment choice.