NPV is the difference between the present value of cash inflows and the present value of cash outflows over time. It tells you in dollar terms whether an investment creates or destroys value.
Interpretation: Positive NPV of $773 means the project creates value. At a 10% discount rate, you earn more than your cost of capital.
| NPV Result | Decision | Meaning |
|---|---|---|
| NPV > 0 (Positive) | Accept project | Creates value, exceeds hurdle rate |
| NPV = 0 | Neutral (breakeven) | Exactly meets required return |
| NPV < 0 (Negative) | Reject project | Destroys value, below hurdle rate |
| Metric | NPV | IRR |
|---|---|---|
| Result format | Dollar amount ($45,000) | Percentage (18%) |
| What it shows | Absolute value created | Rate of return earned |
| Discount rate | You choose (cost of capital) | Calculated automatically |
| Scale consideration | Yes (bigger projects = bigger NPV) | No (% is scale-independent) |
| When to use | Final investment decision | Initial screening, comparison |
The discount rate represents:
| Investment Type | Typical Rate |
|---|---|
| Government bonds (low risk) | 3-5% |
| Established business | 8-12% |
| New venture (medium risk) | 15-20% |
| Startup (high risk) | 25-35% |
$1,000 today vs $1,000 in 5 years:
At 10% discount rate, $1,000 in 5 years = $620.92 today
At 15% discount rate, $1,000 in 5 years = $497.18 today
Higher discount rates make future money worth less today.
Should we buy new machinery? NPV compares upfront cost to future productivity gains.
Is this property development profitable? NPV considers all costs and future sale proceeds.
Should we acquire this company? NPV values future cash flows against purchase price.
Which of 3 projects should we fund? Choose the one with highest positive NPV.
NPV assumes:
- Cash flows occur exactly as predicted
- Discount rate remains constant
- Cash can be reinvested at discount rate
- Doesn't account for flexibility or real options
Use NPV as one tool, not the only decision factor.
Scenario: Company considering $150,000 machine with 5-year life
| Year | Cash Flow |
|---|---|
| 0 (Today) | -$150,000 |
| 1 | $30,000 |
| 2 | $35,000 |
| 3 | $45,000 |
| 4 | $60,000 |
| 5 | $85,000 |
Same project, different discount rates:
| Discount Rate | NPV | Decision |
|---|---|---|
| 8% | $44,956 | Accept (strong positive) |
| 10% | $33,767 | Accept (positive) |
| 15% | $10,533 | Accept (barely) |
| 17% | $1,031 | Marginal |
| 20% | -$11,452 | Reject (negative) |
Higher discount rates reduce NPV. At 20%, this project destroys value.
Three projects, $100k budget, which to choose?
| Project | Initial Cost | NPV at 12% | IRR |
|---|---|---|---|
| Project A | $50,000 | $18,500 | 24% |
| Project B | $80,000 | $31,200 | 19% |
| Project C | $100,000 | $35,000 | 17% |
Software Development Project:
| Year | Cash Flow | Note |
|---|---|---|
| 0 | -$200,000 | Initial development |
| 1 | -$50,000 | More development (negative!) |
| 2 | $40,000 | Launch, slow uptake |
| 3 | $120,000 | Growing rapidly |
| 4 | $180,000 | Mature product |
| 5 | $200,000 | Peak revenue |
Despite two years of negative cash flow, NPV is positive $68k. Project creates value.
Decision: Open second restaurant location
| Year | Revenue | Expenses | Net Cash Flow |
|---|---|---|---|
| 1 | $450,000 | $385,000 | $65,000 |
| 2 | $520,000 | $410,000 | $110,000 |
| 3-10 | Growing 5%/yr | Growing 3%/yr | $130k-$195k |
Decision: Proceed. Creates $135k in value at 18% hurdle rate.
Homeowner decision: Install solar panels
Decision: Install panels. Positive NPV of $13k means financial sense.
Evaluate: Purchase rental property
Decision: Reject. Negative NPV means return below 12% hurdle rate. Better opportunities exist.
Complete this 10-question quiz on NPV
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