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It is important to know what net present value (NPV) is before proceeding to calculate NPV. NPV is defined as the sum of the present values of a time series of cash flows. It is a widely used method for using the time value of money to determine the value of long term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or lack of cash flows in current present value terms after the discount rate has been applied. When you calculate NPV, you are summarizing the value of a cash flow over time into a single equivalent number. With the NPV calculated, you can use it to compare with other cash flow streams. This can help you determine which alternative is most economical for your organization.
When you have money coming in and going out over a period of time, you must take into account the time value of money. If you were to just add all the cash flows over time you would be making the assumption that the time value of money or the interest rate is zero.
To determine the NPV of a set of cash flows, you must use an interest rate that defines the current time value of money. Each organization should decide what that interest rate is. It should include a base rate (probably a government set rate) and an inflation rate (current industry inflation rate). Each cash flow must be brought back to present with a reverse compounding method.
The NPV Calculator has a built in example to help you understand how it works. When you have used the calculator with your own data, you can use the results to compare multiple projects.
When you calculate NPV, you have a number that is convenient to compare other projects with. You want to choose the highest NPV projects as the ones that provide the most profit to your organization. If your project only represents costs, then you want to choose the project with an NPV closest to zero.
