net present value (npv)

Definition:
The Net Present Value method (NPV) is a traditional valuation method (often for a project) used in the Discounted Cash Flow measurement methodology, whereby the following steps are undertaken:

1. calculation of expected free cash flows (often per year) that result out of the investment
2. subtract /discount for the cost of capital (an interest rate to adjust for time and risk) The intermediate result is called: Present Value.
3. subtract the initial investments

The end result is called: Net Present Value (NPV)

Comment:
So NPV is an amount that expresses how much value an investment will result in. This is done by measuring all cash flows over time back towards the current point in present time. If the Net Present Value method results in a positive amount, the project should be undertaken. Although Net Present Value measurement is widely used for making investment decisions, a disadvantage of Net Present Value is that it does not account for flexibility / uncertainty after the project decision. A business strategy should be considered much more like a series of options than a series of static cash flows. As a result, in valuations that involve significant future flexibility and/or uncertainty is involved and/or future cash-flows alone are close to break-even, such as long-term strategic scenario's, flexibility has become a major source of value and option (real options) value must be taken into consideration then. The following variables determine the value of having (an) option(s) (Black-Scholes and other):

• Time to expiration (duration)
• Degree of uncertainty
• Cost of acquiring the option(s)
• Potential cash flows lost compared to full upfront commitment
• Risk-free interest rate
• Expected present value of future cash flows

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