Understanding net present value
The net present value (NPV) of an investment proposal is equal to the present value of its annual free cash flows minus the initial cash outlay. The NPV can be expressed as follows:
NPV = – (initial investment) + (present value of all the future annual free cash flows) or
= Initial Investment, C= Cash flow,
r = discount rate and T = time
When any investor takes on a project or investment, it is important to make an estimate of how profitable the venture will be. In the formula, the C0 is the initial investment, which is a negative cash flow showing that money is going out as opposed to coming in. Since the money going out is subtracted from the discounted sum of cash flows coming in, the NPV has to be positive in order to be considered a valuable investment. The formula for the discounted sum of all cash flows can be rewritten as:
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