NPV is defined as the total present Value of the future cash flow minus the initial investment capitalized at the year zero. Put simple, the NPV compares the value the project creates (PV of the cash flow) to the initial investment required to implement it. So, it basically measures the value creation attainable to the project.

The interest rate utilized to calculate the NPV should be the Cost of Capital or the Rate of Return expected to be earned on the investment. Theoretically, it should be at least the highest return rate that the investor can earn on her best alternative investment.

NPV returns the net value of the cash flows — represented in today's dollars. Because of the time value of money, receiving a dollar today is worth more than receiving a dollar tomorrow. NPV calculates that present value for each of the series of cash flows and adds them together to get the net present value.

NPV determines whether a project earns more or less than a desired rate of return (also called the hurdle rate) and is good at finding out whether or not a project is going to be profitable. IRR goes one step further than NPV to determine a specific rate of return for a project. Both NPV and IRR give you numbers that you can use to compare competing projects and make the best choice for your business.

To properly use the NPV, evaluators must make sure they are comparing values on the same basis (apples to apples). For example, if the project is entirely financed with money from investors (no financing involved), all the cash flow generated by the project will be owned by those investors and the NPV would be calculated by subtracting the total project investment from the PV of the project cash flow.

If the project is partially financed with debt, as is the case with most large projects, the NPV calculation will utilize only the cash flow available to investors compared to the actual investment they have made. This is equivalent to having a cash flow only of the investor’s money (equity).

Similarly, if evaluators wish to calculate the return for one particular investor, they would have to compare the PV of the Cash Flow available to that investor, to the initial investment he made.

The calculations involved to obtain the Cost of Capital are detailed in this book.

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.