Net present value (NPV) is a very reliable and widely used method for comparing the financial outcomes of different projects or investments. With the NPV calculation, we can find the net financial benefit of a project with expected expenses and gains spread out to many time periods by considering the time value of money.

Net Present Value Overview (NPV)

Actually, NPV has the same logic of the present value and future value calculations, but its name and definition may make you think that it is a totally different method. Let’s illustrate why. Let's say that you have a project idea and the expected cash flow of the project is as shown on the following table:

Look at the net cash flow values, which is the difference between gains and expenses. In the first two years, the project is expected to result in losses due to the project spendings and after the second year the project is expected to result in profits. From the bottom-right corner of the table, we also see that the project is expected to generate a net profit of $20,000 at the end, which is calculated by subtracting the total of all the expenses from the total of all the gains. In this calculation note that this net profit does not consider the time value of money. However, an amount of money at the present time is more valuable than the same amount of money in the future.

Think about the expense at the end of the first year (-$20,000) and the expense at the end of the second year (-$20,000) on the previous table. They’re both the same value, however, the money spent in the second year can earn interest during the first year of the project, while the money spent in the first year can’t earn any interest. Additionally, the present value of the $20,000 spent in the second year is also less than the $20,000 spent in the first year due to inflation. To summarize, we can say that an amount of future spending in the project is always better than the same amount of initial spending in terms of financial gains.

The vice versa is also true. Any gain realized in the first year would this time be more valuable than a gain in the later years because of the decrease in the purchasing power of the money due to inflation. Additionally, if a project results in gains in the first year, this money would also be able to earn more interest compared to the money gained in the later years.

When we want to consider the time value of money as we do in the present value and future value calculations, and if we have lots of time periods with different gains and expenses, we can use the net present value (NPV) to evaluate and compare different project alternatives.

What Is Net Present Value (NPV)?

Net present value (NPV) is the sum of the present values (PV) of all future cash flows of an investment. The reason it is named as “net” present value is because the NPV calculates the “net” cash flow by finding the present values of all the gains and the expenses, and then adds them up in order to find the “net” present value of the whole project or investment. Note that when you find the net cash flow of a project, the years with losses will be in negative values and the years with gains will be in positive values. And when you add their present values all together, the result you will get is also going be a net value.

That is why the project alternative with a positive NPV means that the project will generate gains on investment, while a negative NPV means that the project will result in losses on investment, which is also important to know for the PMP and CAPM exams. When selecting projects according to their NPV, the project with the highest positive NPV will be the most profitable project compared to others. 

PMP And CAPM Exam Tips On Net Present Value

On the PMP or the CAPM exam, it is unlikely that you will need to make an NPV calculation. Thoroughly knowing the logic of NPV is the most important part. A positive NPV will mean the project will generate gains and a negative NPV will mean that the project will result in losses.

If you are asked to compare different project alternatives, the one with the highest NPV will be the most profitable project compared to others. At last, a project alternative that does not align with the strategic goals of the company is not going to be the best choice on the exam, even it has the best NPV value.