Net Present Value (NPV)

 

 

Miranda

The NPV indicates an investment’s net value of in today’s dollars. All costs and benefits are adjusted to "present value" by using discount factors to account for the time value of money.  NPV is a way of making costs and benefits occurring in different years commensurable.  It is the algebraic combination of the present value of costs and benefits.  OMB Circular A-94 establishes NPV as the standard criterion for deciding whether a government project’s costs can be justified on economic principles.  According to OMB Circular A-94:

 

Q & A

QUESTION: What is Net Present Value?

 

ANSWER: : In the most general terms (again consistent with OMB Circular A-94), NPV is defined as the difference between the present value of benefits and the present value of costs.  All costs and benefits are adjusted to "present value" by using discount factors to account for the time value of money. The benefits referred to above must be quantified in cost or financial terms in  order to be included in the equation below.  

 

NPV forecasts when the investment will generate sufficient cash flows to repay the invested capital and provide the required rate of return on that capital.  Because all cash flows are discounted back to the present time, the NPV compares the difference between the present value of the benefits and costs and takes into account what the project gives up to get these benefits, or the opportunity costs of both cash flows.  

 

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Calculating Net Present Value

 

“Net present value is computed by assigning monetary

values to benefits and costs, discounting future benefits and

costs using an appropriate discount rate, and subtracting the

sum total of discounted costs from the sum total of discounted benefits. Discounting benefits and costs transforms gains and losses occurring in different time periods to a common unit of measurement.

 

 

 

Mathematically, NPV is calculated as shown:

 

A formula for NPV

 

For most government generated cost estimates, discount rates provided in OMB Circular A-94 are used to discount all cash flows as shown:

 

Another formula for NPV

 

Projects with positive net present value increase social resources and are generally preferred.  Projects with negative net present value should generally be avoided.”

 

 

Projects with negative net present value should generally be avoided.