When selecting a project for capital investment, individuals and companies use a net present value discounting model. Net present value is the difference between the current value of the cash inflows and cash outflows of a project. A positive net present value shows that a project is profitable. A negative net present value indicates that a project is going to make a loss. However, net present value has advantages and disadvantages.
Net present value takes into account all cash flows and reviews the total earnings during the life of a project, thereby showing the overall profitability of an investment. Net present value also incorporates the time value of money. This refers to the principle that the value of a sum of money today is less than the value of the same sum in the future. Net present value shows whether an investment grows enough over time to improve the value of a sum of money.
Net present value allows an individual investor to compare two investment projects that have the same cash outflows. An organisation can also use such a comparison to show the value of potential investment options to its stakeholders. A further advantage of net present value is that it expresses both cash inflows and outflows in the current value of the potential investor's currency. This allows an investor to evaluate a project on its own merits in straightforward terms.
A net present value calculation incorporates the current value of the initial capital outlay for a project, the cash inflow for a given future period, and the projected lifespan of the project. All three of these may change either before a project starts or during the course of a project. Such changes mean that an original net present value calculation could be wrong by the time a project is complete. This would affect a project's anticipated rate of return.
An investor refers to the anticipated rate of return from a project as the discount rate. This rate is often the same as the cost of capital, which corresponds to the interest rate charged by a lender for any capital an investor borrows. However, the interest rate and therefore the discount rate may change as a project progresses. Such changes alter the original net present value and create a problem for long-term capital budgeting.