A popular mechanism of measuring the discounted cash flow value of the profit
| NPV = \sum_{i=0}^n \frac{R_{t_i}}{(1+r)^{t_i}} = R_0 + \sum_{i=1}^n \frac{R_{t_i}}{(1+r)^{t_i}} |
where
n | total number of time steps (usually time step is one year) |
|---|---|
t_i | time passed since the first investment ( assuming that t_0 = 0) |
r = \rm \frac{Cash_{out} - Cash_{in}}{Cash_{in}} | the discount rate, i.e. the return that could be earned per unit of time (usually one year) on an investment with similar risk, which is assumed constant over time |
R_{t_i} = \rm Cash_{in}(t_i) - \rm Cash_{out}(t_i) | the net cash flow at time step t_i |
R_0 = - \rm Cash_{out}(t=0) | the volume of cash investment at initial time moment t_0 = 0 |
The main idea of NPV is to start wth the statement that value of cash today is higher than value of cash tomorrow because immediate cash can be safely invested today and start brining some profit.
In a sense, NPV is showing a value of given investment as against competition in the form of the available market investment opportunities
NPV dictates that commercial project should not only be just profitable but instead should be on par with or more profitable than easily available investment alternatives
The corporate investment policy usually dictates that:
investment projects with negative NPV should be rejected
investment projects with higher NPV should have a financing priority over the projects with lower NPV