Net Present Value (NPV) is a method to analyze the profitability of a project by weighing the investment against the projected future returns. NPV would be positive when the value of projected returns exceeds the investment, and negative otherwise. One advantage of NPV is that it gives a solution without the need to evaluate project length. For these reasons, it is appropriate to choose a project based on NPV comparison.
What Is Net Present Value (NPV)?
Net Present Value (NPV) is used to determine whether a project will generate value. It is the difference between the sum of the present values of future cash flows and the initial cash outlay. Because NPV incorporates the time value of money, it is one of the best metrics for project selection.
What Is Present Value (PV), and How Does It Relate to NPV?
Present Value (PV) is the discounted value of a future cash flow. NPV is the sum of the PVs of cash flows, less the initial cost. PV is calculated for a single cash flow, and NPV is calculated for all cash flows that will occur in the project.
PV = FV / (1 + r)^n
Where FV is the future cash flow, r is the discount rate, and n is the number of periods until that cash flow occurs.
A full comparison of Present Value and Future Value, including worked examples across multiple time horizons, is a substantial topic in its own right and will be covered in a dedicated guide.
What Is the Net Present Value Formula?
The Net Present Value Formula calculates the present value of each of the future cash flows and then subtracts the initial investment of the project: NPV = Σ [Cash Flow / (1 + r )^t] – Initial Cost.
- Cash Flow (C) — the net revenue or cost generated in a given period, usually a year.
- Discount Rate (r) — the rate used to convert future cash flows into today’s dollars, reflecting the cost of capital or required return.
- Time Period (t) — the number of periods, typically years, from now until the cash flow occurs.
- Initial Cost (C₀) — the upfront investment required to start the project.
How Do You Calculate Net Present Value?
A project manager discounts each of the cash flows to their present value, sums the value of each period and subtracts the initial investment.
A facilities modernization project requires an initial investment of $50,000 and is expected to generate the following cash flows over three years, discounted at 8%:
- Year 1: $20,000
- Year 2: $25,000
- Year 3: $15,000
PV (Year 1) = $20,000 / (1.08)¹ = $18,518.52 PV (Year 2) = $25,000 / (1.08)² = $21,433.47 PV (Year 3) = $15,000 / (1.08)³ = $11,907.48
Sum of PVs = $18,518.52 + $21,433.47 + $11,907.48 = $51,859.47
NPV = $51,859.47 − $50,000 = $1,859.47
The project returns a positive NPV of approximately $1,859, indicating it creates value even after accounting for the time value of money — a thin margin, but a favorable one.
How Do You Interpret an NPV Result?
A positive NPV indicates a project creates value after discounting. A negative NPV indicates a project’s value is lost. A value of exactly zero means a project breaks even.
- NPV > 0 — the project is financially favorable; discounted returns exceed the initial investment.
- NPV = 0 — the project breaks even; discounted returns exactly equal the initial investment.
- NPV < 0 — the project is financially unfavorable and should generally be rejected on financial grounds alone.
How Do You Use NPV to Compare Multiple Projects?
Multiple projects’ rankings based on greatest dollar value from NPV is the strongest financial selection, regardless of majority or minority time requirement for each project, since NPV considers the time value of the money.
Two proposals compete for the same capital:
- Project M: NPV = $45,000, completed over 4 years
- Project N: NPV = $38,000, completed over 7 years
Project M carries the higher NPV despite its shorter timeline, and Project N’s longer duration does not offset its lower NPV — the discounting already priced in the extra years. Project M is the stronger choice.
What Inputs Does the NPV Formula Require?
Four inputs comprise the NPV formula: the expected cash flows, a discount rate, the time value of each cash flow, and each cash flow’s initial cost. Some NPV formulas also include a terminal value for assets which will continue to have value even after the forecast period.
- Cash Flows — projected net revenue or savings for each period, typically estimated from a business forecast.
- Discount Rate — the rate reflecting the organization’s cost of capital or required rate of return.
- Time Period — the number of periods between now and each cash flow.
- Initial Cost — the upfront capital required to launch the project.
How Does NPV Compare to BCR and ROI?
NPV adjusts the expected profit to reflect the time value, BCR adjusts expected profit to reflect relative size, and ROI adjusts expected profit to reflect relative size and, therefore, NPV adjusted expected profits, BCR adjusted expected profits and ROI adjusted expected profits complement each other and are not used in substitution. A project manager prepares a full business case that incorporates all of these be used in conjunction with NPV.
How Does NPV Appear on the PMP Exam?
Conceptual interpretation and project-by-project comparisons are how the PMP exam assesses NPV, whereas the other, more detailed calculations, are not required. Test takers must understand that in the context of NPV, a longer project is not necessarily a better project. They must also understand that projects with negative NPV must be rejected. Lastly, testers must understand the Present Value framework in which each of the cash flows is individually discounted to the current time.
Sample Question 1: Four projects are under consideration. Project E has an NPV of $85,000 over 4 years. Project F has an NPV of $62,000 over 2 years. Project G has an NPV of $91,000 over 9 years. Project H has an NPV of −$12,000 over 1 year. Which project should be selected? A) Project E B) Project F C) Project G D) Project H
Sample Question 2: What is the correct definition of Present Value? A) The value of assets a company currently owns B) Today’s value of a future cash flow, adjusted for the time value of money C) The future value of money held today D) The current value of today’s assets adjusted for inflation
Sample Question 3: A project requires a $10,000 initial investment and generates a single cash flow of $12,000 after one year, discounted at 5%. What is the project’s NPV? A) $2,000 B) $1,429 C) $571 D) $12,000
Sample Question 4: A project’s NPV is calculated at exactly $0. What does this indicate? A) The project should be rejected outright B) The project’s discounted returns exactly equal its initial investment C) The calculation contains an error, since NPV cannot equal zero D) The project is highly profitable
Answers: 1) C — Project G has the highest NPV at $91,000; duration is already priced into NPV through discounting and does not factor into the comparison separately. 2) B — Present Value is today’s value of a future cash flow, discounted for the time value of money. 3) B — PV = $12,000 / 1.05 = $11,428.57; NPV = $11,428.57 − $10,000 = $1,428.57, rounding to $1,429. 4) B — an NPV of zero means the project breaks even, with discounted returns exactly matching the initial investment.
Frequently Asked Questions
Do You Need to Calculate NPV on the PMP Exam?
The PMP exam focuses more on understanding the concepts and project-comparison scenarios. Candidates are better off understanding what NPV means rather than learning the steps to calculate it.
What Is a Good Discount Rate to Use?
Organizations determine a good discount rate based on cost of capital or required rate of return. This rate is used consistently for all projects. Longer projects will have more value than shorter projects with a higher discount rate.
Can NPV Be Used Alongside BCR and ROI?
NPV is useful when BCR and ROI are used. Focusing on only one of these will give an incomplete analysis. NPV provides additional information and helps analyze the project further.
What Is the Difference Between NPV and Present Value?
Present value calculates the value of a single future cash flow in present-day dollars. Net present value, on the other hand, totals all the future value cash flows for a project and subtracts the initial cost. Present value is the building block of net present value. NPV is the result at the project level.
