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Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account.

NPV is calculated using the following formula:

NPV= -C0 + C11+r+ C21+r2+…+ Ct(1+r)t

- C0 = initial investment C = cash flow r = discount rate t = time

If the NPV of a prospective project is positive, the project should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

Example of Net Present Value

To provide an example of Net Present Value, consider a company who is determining whether they should invest in a new project. The company will expect to invest $500,000 for the development of their new product. The company estimates that the first year cash flow will be $200,000 the second year cash flow will be $300,000, and the third year cash flow to be $200,000. The expected return of 10% is used as the discount rate.

The following table provides each year's cash flow and the present value of each cash flow. Year | Cash Flow | Present Value = FV(1+r)t | 0 | - 500,000.00 | -500000/(1.10)^0 = -500000.00 | 1 | 200,000.00 | 200000/(1.10)^1 = 181,818.18 | 2 | 300,000.00 | 300000/(1.10)^2 = 247,933.88 | 3 | 200,000.00 | 200000/(1.10)^3 = 150,262.96 | NPV = -500000.00 + 181,818.18 + 247,933.88 + 150,262.96 = $80,015.02 | The project should be taken. |

2. Internal rate of return:

Internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake…...

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