The Net Present Value (NPV) is used to assess the profitability of an investment in monetary units. To do this, the receipts and payments that will occur during the course of the investment are discounted and the difference between them is calculated. In addition, we have to discount the flows by a rate.
An interest rate must be applied to the cash flows, equal to the profitability that we could have obtained if we had made the same investment in a financial product. In general, if we are valuing a project that has no risk, we will take the fixed income interest rate as the minimum interest rate of the investment. A project or an investment is profitable when the NPV is greater than zero. If the NPV were zero, we would recover the money invested plus the profitability of the fixed interest rate
Let's see how to obtain the NPV formula:
First, we will enter the payment or investment that we will make at the initial moment: C with a minus sign in front of it.
Next, we will add up each of the flows that we will receive, at a different time F.
The number of time periods is n:
Therefore, we can express NPV as:
Where:
t is each of the periods in which there is a flow.
r is the interest rate required for the investment.
The NPV allows us to know if an investment is profitable and to compare various investments.
Summarizing:
- NPV > 0; It means that the investment will produce profits higher than the profitability that we demand to the investment to consider it suitable, so we must undertake the investment.
- NPV = 0; Means that the investment will offer us the same profitability as the financial product from which we have taken the reference interest rate.
- NPV <0; A result less than zero means that the investment will produce a lower return than the reference financial product or it will produce losses, so we should reject the project.
If the only criterion for deciding on an investment were profitability, we would choose the investment with the highest NPV