How is Net Present Value (NPV) calculated?

The calculation of Net Present Value (NPV) is fundamentally about assessing the profitability of an investment over time by taking into account the time value of money. The correct approach to calculate NPV involves determining the present value of all future cash flows generated by an investment and then subtracting the initial investment cost.

When calculating NPV, you first estimate all future cash inflows expected from the investment. These cash flows are then discounted back to their present value using a specific discount rate, which reflects the risk of the investment and opportunity cost of capital. After obtaining the present value of the future cash flows, you subtract the initial investment; this outcome gives the NPV.

A positive NPV indicates that the projected earnings (adjusted for time and risk) exceed the anticipated costs, suggesting that the investment is likely to be profitable. Conversely, a negative NPV suggests the investment might lead to a net loss.

The other choices reflect misunderstandings about NPV. One talks about future cash flows minus operating expenses, which does not account for the time value of money or initial investments. Another option suggests summing current investments with future cash flows, which fails to incorporate discounting and the concept of time value. The last option regarding average returns does not inform about