Net Present Value (NPV) is the difference between the present value of all future cash inflows and the present value of all cash outflows (including the initial investment), discounted at the investor's required rate of return.
Formula: > NPV = Σ [CF_t ÷ (1 + r)^t] − Initial Investment
Where: - CF_t = cash flow at time t - r = discount rate (required rate of return) - t = time period
Decision rule: - NPV > 0 → Accept (investment generates more than the required return; creates value). - NPV = 0 → Indifferent (investment earns exactly the required return). - NPV < 0 → Reject (investment destroys value).
Example: Initial investment: $100,000. Annual cash flows: $30,000/year for 5 years. Required return: 8%. - PV of cash flows = $30,000 × PVIFA(8%, 5) = $30,000 × 3.993 = $119,790. - NPV = $119,790 − $100,000 = +$19,790 → Accept.
NPV vs. IRR: - NPV gives a dollar amount of value created. - IRR gives a rate of return — the discount rate that makes NPV = 0. - When NPV and IRR conflict (mutually exclusive projects), NPV is preferred because it measures absolute value creation.
Reinvestment assumption: NPV implicitly assumes cash flows are reinvested at the discount rate (r). IRR assumes reinvestment at the IRR — which may be unrealistic if IRR is very high.
> Exam tip: Positive NPV = accept the investment. NPV is the gold standard of capital budgeting. For the CFP® exam, know the NPV formula, the decision rule, and why NPV is preferred over IRR for mutually exclusive projects.