Why future money gets discounted
Money received next year is worth less than money today for three reasons: today's money could be invested and earn a return, inflation erodes what future money buys, and future cash flows carry risk of not arriving. The discount rate rolls all three into one percentage.
Each year's cash flow is divided by (1 + rate)^year. At a 10% rate, 25,000 received in year one is worth about 22,727 today; the same amount in year seven is worth only about 12,829. Distance shrinks value.
Choosing the discount rate
Companies typically use their cost of capital, often 8 to 15%. The logic: a project must beat what the same money costs to raise, or earns elsewhere at similar risk, to be worth doing. Riskier projects deserve higher rates.
NPV is highly sensitive to this choice, which makes it worth testing a range. A project that only shows positive NPV at optimistic discount rates is telling you something.
Frequently asked questions
What does a positive NPV mean?
The project's discounted future cash flows exceed the initial investment, so it creates value at your discount rate. Between competing projects, the higher NPV creates more value.
What discount rate should I use?
Your cost of capital or required return, commonly 8 to 15% for businesses. Use higher rates for riskier cash flows.
What is the profitability index?
Present value of inflows divided by the initial investment. Above 1 means positive NPV. It is useful for ranking projects when capital is limited.
How does NPV differ from IRR?
NPV gives a value in currency at your chosen rate. IRR finds the rate at which NPV equals zero. They usually agree on accept/reject but can rank competing projects differently.
Can I model uneven cash flows?
This calculator uses equal annual cash flows for clarity. For uneven flows, the same discounting applies to each year individually.
Does NPV account for inflation?
Implicitly, if your discount rate includes it and your cash flows are in nominal terms. Keep both nominal or both real; mixing them is the classic error.