NPV (Net Present Value): how to know if an investment is really worth it
Every investment decision boils down to one essential question:
Is it worth risking my money here?
In business —and in life— it’s not only about how much you earn, but when you earn it. Receiving €10,000 today is not the same as receiving it three years from now.
Net Present Value (NPV) answers exactly that. It tells you what future cash you expect to receive is worth today, and whether the investment creates more value than it costs.
In this article you’ll learn what NPV is, how to calculate it, how to interpret it, and when to use it to decide whether an investment is truly worth it.
What is NPV (Net Present Value)
NPV is a financial metric that estimates the profitability of an investment by discounting the time value of money.
Put simply: NPV compares the money you invest today with the present value of the future cash flows the investment will generate.
- NPV > 0: the investment creates value.
- NPV = 0: you earn exactly your cost of capital, with no extra value.
- NPV < 0: the investment destroys value.
That’s why NPV is considered one of the most reliable criteria for evaluating projects.
The logic behind NPV: the time value of money
NPV starts from a basic principle: money has a time value.
One euro today is worth more than one euro tomorrow, because you can invest it, reduce risk, or avoid costs. So future cash flows must be “brought back” to today using a discount rate, which represents your opportunity cost (what you could earn in the best available alternative, adjusted for risk).
The NPV formula
A clear way to express it is:
NPV = Σ (CF_t / (1 + r)^t) − Initial investment
Where:
CF_t= expected net cash flow in period tr= discount rate (opportunity cost / cost of capital)t= periods (years, months, etc.)n= total project duration
A simple practical example
Suppose you invest €10,000 today and the project pays you €4,000 per year for 3 years. Your discount rate is 10%.
Approximate calculation:
- Year 1: 4,000 / 1.10 = 3,636
- Year 2: 4,000 / 1.10² = 3,306
- Year 3: 4,000 / 1.10³ = 3,005
Sum of present values ≈ 9,947
NPV ≈ -53 €
Interpretation: the project is basically break-even versus a 10% required return. It doesn’t compensate you beyond your opportunity cost.
If you reduce the discount rate to 8%, NPV turns positive:
NPV ≈ +308 €
Meaning it creates additional value under that cost of capital.
How to interpret NPV
| Result | Meaning | Typical decision |
|---|---|---|
| NPV > 0 | Discounted benefits exceed the cost of capital | Accept |
| NPV = 0 | You earn exactly the cost of capital | Indifferent |
| NPV < 0 | It doesn’t cover opportunity cost and risk | Reject |
As a rule of thumb, you should invest only when NPV is positive — unless there’s a very clear strategic reason.
The discount rate: the factor that changes everything
The discount rate is the core of NPV.
- If it’s too low, you overvalue the future (everything looks profitable).
- If it’s too high, you undervalue opportunities (you reject good projects).
In companies, the reference is often WACC. In smaller projects, you can estimate it by adding:
- a risk-free rate (e.g., sovereign bonds),
- a business/sector risk premium,
- (if relevant) an expected inflation premium.
Example: 3% + 5% + 2% = 10%.
NPV vs. IRR and Payback
NPV vs. IRR
IRR (Internal Rate of Return) is the discount rate r that makes NPV equal to zero. If:
- IRR > cost of capital → the project is attractive
- IRR < cost of capital → the project is unattractive
NPV is often better to understand how much value (in euros) a project creates, while IRR gives you a percentage.
NPV vs. Payback
Payback tells you how long it takes to recover the initial investment, but it usually ignores the time value of money. That’s why NPV is more rigorous.
- Payback: when you recover
- IRR: at what rate you recover
- NPV: how much net value remains
Advantages of NPV
- Measures value, not only a percentage return.
- Incorporates the time value of money.
- Helps rank projects by value creation.
- Works well with scenarios (different rates, horizons, risk).
- It’s a standard in corporate finance and valuation.
Limitations of NPV
- Relies on assumptions: cash flows are forecasts.
- Highly sensitive to the discount rate.
- Doesn’t capture managerial flexibility well (expand, pause, exit).
- Over-optimistic inputs lead to misleading results.
That’s why it should be paired with sensitivity analysis.
Full example: choosing between two investments
Two projects with the same initial cost:
| Item | Project A | Project B |
|---|---|---|
| Initial investment | €10,000 | €10,000 |
| Cash flow year 1 | €3,000 | €4,000 |
| Cash flow year 2 | €4,000 | €3,000 |
| Cash flow year 3 | €5,000 | €3,000 |
| Discount rate | 10% | 10% |
Result (approx.):
- NPV_A ≈ -210 €
- NPV_B ≈ -1630 €
Even though both are negative at this discount rate, A destroys far less value than B. If you had to pick, A would be the “least bad” choice financially.
NPV in real business decisions
NPV is commonly used to evaluate decisions such as:
- buying machinery or technology,
- launching a new business line,
- expanding a plant or location,
- acquiring/merging with another company,
- launching a product.
Sensitivity analysis: what if assumptions change?
NPV becomes especially useful when you ask “what if…?”:
- What if sales are 10% lower than expected?
- What if the discount rate rises from 8% to 12%?
- What if costs increase by 15%?
If small changes turn NPV negative, the project is fragile. If it stays positive across scenarios, it’s robust.
Common mistakes when using NPV
- Using accounting profit instead of cash flows.
- Missing hidden costs (installation, training, taxes, maintenance).
- Choosing the wrong discount rate.
- Forgetting residual value (resale/asset value at the end).
- Assuming constant growth without evidence.
NPV as a compass for smart investing
NPV is quantified common sense: it tells you whether the future you expect is worth what you give up today.
It doesn’t guarantee success, but it prevents impulsive decisions, makes risk measurable, and forces you to think like an investor: value, time, and risk-adjusted returns.