Section 3 of 6
Money received today is worth more than the same amount received in the future because:
Net present value (NPV) — a capital investment appraisal method that discounts all future net cash flows to their equivalent value in today's money, then deducts the initial cost. A positive NPV means the project earns more than the required rate of return.
| Term | Definition |
|---|---|
| Cost of capital | The discounting rate used — either the interest rate on borrowed funds or the minimum rate of return required by the business |
| Discount factor | A figure (between 0 and 1) applied to a future cash flow to convert it to its present value; found from discount factor tables |
| Present value | A future cash flow × its discount factor |
| Net present value | Sum of all present values (including the Year 0 outflow) |
The Year 0 (beginning of project) discount factor is always 1.000 — money spent now is already at present value.
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| Factor | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Factors decrease over time — money received further in the future is worth less today.
| Year | Cash flow (£) | Discount factor (10%) | Present value (£) |
|---|---|---|---|
| 0 | (40 000) | 1.000 | (40 000) |
| 1 | 12 000 | 0.909 | 10 908 |
| 2 | 18 000 | 0.826 | 14 868 |
| 3 | 10 000 | 0.751 | 7 510 |
| 4 | 9 000 | 0.683 | 6 147 |
Positive NPV → project earns more than 10% → financially viable
Choose the project with the higher positive NPV.
If a project has a negative NPV, the sum of discounted future cash flows does not cover the initial investment at the required rate of return — it should not be undertaken on financial grounds alone.
When choosing between two suppliers or contracts (both are costs, no revenue), use NPV to find the lowest net present cost — this is the preferred option.
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| 5 |
| 5 000 |
| 0.621 |
| 3 105 |
| NPV | +£2 538 |