Net Present Value (NPV) is one of the most widely used financial metrics for evaluating investment opportunities and potential projects. Whether you're a vendor or buyer, a budget owner overseeing 100 projects, or a PM of a single project, understanding NPV is crucial for making informed, value-based decisions. In this blog post, we’ll break down what NPV is, why it matters, how it’s calculated, and its pros & cons compared to other well-known financial metrics.
Introducing NPV
NPV stands for “Net Present Value” and at its most basic level, it helps determine whether an investment is likely to be profitable or not, by calculating the difference between the present value of a project’s cash flows (Benefits minus Costs), over time, discounted at a specific rate.
Why does NPV matter?
For the vast majority of projects, before it’s signed off the question we’re trying to answer is “Is this project worth us investing our time and money in?”. The Time Value of Money concept tells us that a dollar today is worth more than a dollar received in the future, and when we understand that, we can see that this is a key area where NPV has the edge over other financial metrics such as payback period or Return on Investment (ROI), as NPV discounts future cash flows. In very simplified terms, if the NPV is positive then it is generating more value than it costs, therefore all other things being equal, it is likely to be a viable project.
What do I need to calculate NPV?
Ct = forecasted cash flows (i.e. the sum of expected Benefits - the sum of expected Costs)
r = the rate at which you will discount future cashflows, often defined as the “cost of capital”
t = the time period of the investment/project
C0 = the initial cost of the project
What is the formula for NPV?
NPV = ∑ (Ct / (1+r)^t) - C0
What are the pros and cons of NPV, relative to other common financial metrics?
Pros
Time Value of Money - this is the key benefit of NPV over other metrics such as ROI and payback period, because as we discussed earlier, the value of money over time is not constant, and NPV accounts for this.
Simple to understand output - although not the simplest calculation in the world, the fact that the output of NPV is a currency value rather than a % (e.g. IRR) means it is simple enough for anyone to understand; at its most basic level a positive NPV means that a project delivers more benefits than it costs so is likely viable, whereas a negative NPV means that the costs outweigh the benefits so it is likely not viable.
Cons
Complicated calculations - although the output is simple to understand, accurately calculating NPV requires a detailed understanding of present value, cashflows, inflation and discount rates. This is why rather than calculating the figures manually themselves in spreadsheets, many firms instead rely on platforms such as KangaROI to do the heavy lifting for them.
Absolute not relative returns - NPV is only concerned with the absolute return of a Project, so does not legislate for the size of the investment or the amount of time required to achieve that value. This means that a Project returning $100,000 over a 5-year period would appear more favorable than a Project returning $99,000 over a 1 year period.
Accuracy of inputs - like any formula or metric, NPV is only as useful as the numbers being plugged into it, so although NPV can be used to retrospectively evaluate projects, it is largely used to take a forward-looking view of projects that are yet to happen, so in that scenario, it’s accuracy is down to the quality of the forecasts:
Discount rate is not easy to accurately forecast ahead but it is a key element of the NPV calculation, so a small discrepancy can have a large impact on the NPV calculation, something that is particularly relevant for longer projects.
Similarly, future cashflows (both Benefits and Costs) are difficult to forecast accurately.
Non-financial factors - NPV is purely focused on the financial side, therefore it doesn’t take into account non-financial factors that can be important to the perceived success of a project, such as the impact it has on the environment, internal company innovation, brand image, strategic alignment etc
Summary
Net Present Value is an extremely useful metric, but should not be used in isolation, which is why every Business Case and Project on the KangaROI platform considers NPV alongside other metrics such as Return on Investment (ROI) and Discounted Payback Period to give a complete picture.
