Reading: Net Present Value (NPV)

The Net Present Value (NPV) indicates by how much your net worth increases as a result of a given investment decision:

• Net: All the necessary investments to conduct the project have been accounted for. It is the surplus the project generates after all relevant stakeholders have received their "fair" compensation. This surplus belongs to the owners of the project.
   
• Present Value: It is a dollar (or any other currency) amount today. Put differently, it already reflects the fact that money has a time value and that investors require a certain rate of return to bear the risk that is associated with the investment in question. 
   
• In other words, the NPV tells us how much money the investors make with a project IN ADDITION to the "fair" rate of return that an alternative asset with identical risk would generate.

Remember from the module Time Value of Money that we have derived present values by building a portfolio with the alternative asset that generates the exact same future cash flows as the investment proposal in question (the so-called replicating portfolio). The present value indicates how much we have to invest today to build the replicating portfolio. It is the market price at which we can buy or sell the future cash flows of an investment project using the alternative asset with identical risk.

With this in mind, we can go back to the Example 2 from before and formulate two alternative interpretations of the NPV that might be more intuitive for some readers:

Interpretation 1:

• The present value of 603.3 indicates that you would have to invest 603.3 today in the alternative asset to exactly replicate the cash flows of the project (300 in 1 year and 400 in 2 years).
• With the investment proposal in question, you only have to invest 500 today to gain access to the same future cash flows (at the same risk).
• With the investment proposal, you can therefore save an initial investment of 103.3 today, compared to the alternative asset. That's the net present value of the project.

Interpretation 2:

• Using the alternative asset, you should be able to borrow 603.3 today in exchange for promising future cash flows of 300 in 1 year and 400 in 2 years.
• With the borrowed money, you could invest 500 in the investment proposal and pocket the remaining 103.3.
• In 1 year, the investment proposal generates a cash flow of 300, which you can use to service your debt. Similarly, in 2 years, the investment proposal generates a cash of 400, which, again, you can use to service your debt.
• Taken together, this strategy therefore gives you a cash inflow of 103.3 today and no further cash flows in the future.
• This replicating strategy therefore has a profit of 103.3 today. That's the net present value of the project. The following table summarizes this replication strategy:
   
   
  

  	Today	Year 1	Year 2
  Borrow Alternative Asset	603.3	-300	-400
  Buy Investment Proposal	-500	300	400
  Net Cash Flow	103.3	0	0