NPV

What it means

NPV is the sum of a project’s future cash flows discounted to today, less the initial investment. A euro in five years is not a euro now, and NPV is what accounts for that.

A positive NPV means the project earns more than the capital funding it costs. A negative one means the money would do better elsewhere or repaying debt.

NPV and IRR start from the same flows but answer different questions. NPV says how many euros a project adds, IRR what percentage return it achieves. Choosing between two projects of different size, the smaller may have the higher IRR and the larger the higher NPV; if only one can go ahead, NPV usually decides, because a company lives on euros, not percentages.

How it works in practice

The discount rate is usually the company’s weighted average cost of capital. A riskier project raises it, which discounts distant flows more harshly, and that is the point.

The model includes every flow: the investment, operating receipts and payments, tax, the change in working capital and residual value. Omitting working capital is the classic error.

When applying for an investment loan the bank wants a model with flows and assumptions. From the books we prepare the historical figures the assumptions rest on: monthly sales, margin, the time customers take to pay, so the model stands on verifiable data rather than guesses.

What to watch out for

NPV is sensitive to assumptions. So it is run in several scenarios, watching what fall in revenue or rise in costs flips the project into the red.

A common mistake is to compute NPV from profit instead of cash flows. The investment is then counted twice, once at the start as an outflow and again through depreciation over its life. Depreciation spends no cash and enters the model only indirectly, through the tax it reduces.