What is NPV / Net Present Value (NPV) Method in Capital Budgeting

What is Net Present Value (NPV)?

Net Present Value (NPV) is one of the most popular and useful methods for evaluating investment or project proposals.

In simple words: NPV tells us how much profit we will make from a project, in today’s money terms.

Since money received in the future is not as valuable as money today (because of inflation, risk, and opportunity cost), NPV helps us to calculate the present value of all future cash inflows and cash outflows of a project.

Formula of NPV:

NPV = ∑ [ Rₜ / (1 + k)ᵗ ] + [ Sₙ / (1 + k)ⁿ ] - [ C + Wₙ / (1 + k)ⁿ ]

Where:
Rₜ = Cash inflow in year t
k = Discount rate (Cost of Capital)
C = Initial cost of the project
Sₙ = Salvage value at the end
Wₙ = Working capital invested
n = Number of years

Let’s Understand With an Example:

Suppose, a company wants to invest ₹1,00,000 in a project. The expected profits after tax and adding back depreciation (cash inflows) for the next 3 years are:

Year	Cash Inflow (₹)
1	40,000
2	50,000
3	60,000

The discount rate is 10%.

Step 1: Calculate Present Value (PV) of each year's inflow

Year	Inflow	PV Factor @10%	PV of Inflows
1	40,000	0.909	₹36,360
2	50,000	0.826	₹41,300
3	60,000	0.751	₹45,060

Total PV of Inflows = ₹1,22,720

Step 2: Subtract the Initial Investment
NPV = ₹1,22,720 - ₹1,00,000 = ₹22,720

Decision: NPV is positive, so the project should be accepted.

Decision Rule (Very Important):

NPV Value	Decision
NPV > 0	Accept the Project
NPV < 0	Reject the Project
NPV = 0	Indifferent (May or May Not Accept)

Advantages of NPV Method:

·       Considers all future income from the project.

·       Takes into account the time value of money.

·       Gives a clear result – either accept or reject.

·       Supports wealth maximisation – which is the goal of every business.

Disadvantages of NPV Method:

·       Complex for beginners – it needs knowledge of discounting and present value.

·       Not easy when comparing projects with different lifespans.

·       Difficult to choose the correct discount rate – it may change over time.

When is NPV Most Suitable?

• When the business has enough funds and no financial constraints.
• When the aim is to increase shareholders’ wealth and maximise the market value of shares.

In such cases, management should accept all projects with zero or positive NPV.

Conclusion:

The Net Present Value (NPV) Method is a powerful tool for evaluating long-term investments. It helps businesses make informed decisions by comparing today's value of future income and expenses. Even though it’s a bit technical, with practice and understanding, it becomes a reliable method to grow and succeed financially.

 Quick Revision:

·       NPV = Present Value of Inflows – Present Value of Outflows

·       If NPV > 0, project is profitable

·       Use discounting to adjust for time value of money

·       Always think about whether your investment is worth it in today's money!

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