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Net Present Value

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Net present value (NPV) is a method for evaluating the profitability of an investment or project. The net present value of an investment is the present (discounted) value of cash inflows minus the present value of cash outflows. Here's and example of net present value: Suppose an investment requires an initial cash outflow of $5,000 and provides cash inflows of $4,000 in year 1 and $3,000 in year 2. Without using net present value, simply toting up the cash flows sums to +$2,000 (-$5,000+4,000+3,000). With net present value and setting the discount rate to 10%, the investment is worth $1,115.70. (Net present value can be calculated using the NPV function in Excel.) By recognizing the time value of money and equating dollars from different years, net present value makes it possible to evaluate long-term investments. Accurately estimating the cash inflows and outflows for the net present value calculation is tricky; selecting an appropriate discount rate for net present value is also difficult. Nevertheless, net present value is a valuable tool for analyzing capital projects and other investments.



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