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Definition

Net present value (or NPV) or discounted value measures the value of a stream of future cash flows after accounting for the time value of money.[1]

Purpose

Net present value—along with payback and internal rate of return—is one of three metrics commonly used to evaluate return on investment over multiple periods. The purpose of the NPV metric is to summarize the value of cash flows over multiple periods. NPV accounts for the fact that on a per-dollar basis, cash flows received in the future are less valuable than cash in hand.

Construction


      Net present value ($): The present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows

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      Where C is the value of future cash flows, n is the number of periods invested, and i is the discount rate for one period. The discount rate used is the vital consideration and should account for the risk of investment too.

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The figure above shows that a 10% discount rate applied to $1 received now and in each of the next three years reduces in value over time.


References

  1. ^ Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; and David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance (Second Edition). Upper Saddle River, New Jersey: Pearson Education, Inc. <http://www.amazon.com/Marketing-Metrics-Definitive-Measuring-Performance/dp/0137058292>


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