Net present value (NPV)

If a model for a business purchase uses net present value, ask who prepared it and on what inputs. BDC explains that a project’s present value is the value of all its future cash flows today, and that its net present value is that figure less the initial investment. For related terms, see discounted cash flow and how a business valuation is obtained.

How the measure is built

According to BDC, the calculation estimates the cash flows for each year of the project, converts each to today’s dollars using a discount rate, adds them together, and treats the initial investment as a negative cash flow in the first period. BDC says a negative result means the discounted cash flows are less than the initial investment, and a positive result means the project creates value for the business. It also notes that a project can still make sense for reasons that are not strictly financial.

What to check or ask

• Which discount rate was used, and how it was chosen. BDC says it should be realistic, because it converts future cash flows to today’s dollars.
• Where the yearly cash-flow estimates came from, and who stands behind them.
• Whether the model was run under more than one scenario. BDC advises always carrying out a sensitivity analysis, with baseline, optimistic and pessimistic variants based on different cash flows and discount rates.
• Whether alternatives were compared on the same basis. The Treasury Board Secretariat’s Guide to Costing, written for federal departments, says that if the cost of acquiring or disposing of capital assets is relevant to a cost-benefit decision, an NPV methodology should be applied to cash flows to compare alternatives.