Net present value (NPV)

Net present value applies the time value of money — the principle that a dollar today is worth more than a dollar tomorrow — to investment decisions. To compute NPV, you discount each expected future cash flow back to its present value using a required rate of return (the discount rate), add them up, and subtract the initial investment.

Suppose a project costs $1,000 and will pay $600 at the end of each of the next two years, and your required return is 10%. The present value of the cash flows is 600 / 1.10 + 600 / 1.10² ≈ $545 + $496 = $1,041. Subtracting the $1,000 cost gives an NPV of about $41 — the project creates value even after earning the required 10%.

The decision rule is simple: a positive NPV means the investment earns more than the discount rate, so accept it; a negative NPV means it earns less, so reject it; an NPV of zero means it earns exactly the required return. NPV is closely tied to the internal rate of return (IRR) — the IRR is the discount rate that makes NPV equal zero. For bonds, comparing NPV logic to market price explains whether a bond is trading rich or cheap relative to its discounted cash flows.

The Series 65 and Series 66 exams test NPV within time-value-of-money and analytical methods questions — usually conceptually, such as knowing that positive NPV means the return exceeds the discount rate. Business finance programs like the CGMA fundamentals syllabus test NPV as the standard tool of investment appraisal and shareholder wealth measurement.