How is net present value (NPV) calculated?

Net present value (NPV) is a financial metric used to evaluate the profitability of an investment by considering the time value of money. To calculate NPV, future cash flows generated by the investment are first estimated and then discounted back to their present value using a specific discount rate. This reflects the idea that money available now is worth more than the same amount in the future due to its potential earning capacity.

After determining the present value of future cash flows, the initial investment cost is deducted from this sum. Therefore, the formula for NPV can be summarized as:

NPV = Present Value of Future Cash Flows - Initial Investment

This calculation allows investors to assess whether the investment will generate more value than it costs, helping them to make informed decisions on whether to proceed with the investment or not. The choice that reflects this accurate calculation process correctly identifies the essence of NPV assessment in investment decision-making.