How is "net present value" defined?

Net present value (NPV) is defined as the difference between the present value of cash inflows and the present value of cash outflows over a specific period. This concept is foundational in financial planning and capital budgeting, as it helps determine the profitability of an investment or project. By considering both cash inflows and outflows and adjusting these values to present terms using a discount rate, NPV provides a clear metric for assessing whether an investment is likely to be profitable.

The calculation entails discounting future cash flows back to their present value, which incorporates the time value of money—the idea that a dollar today is worth more than a dollar in the future due to its potential earning capacity. When cash inflows exceed cash outflows when discounted back to present value terms, the NPV is positive, indicating a potentially worthwhile investment.

Other choices do not correctly define net present value:

• The total value of cash inflows over a year only considers one side of the equation without accounting for any expenses or outflows, which is essential for calculating NPV.

• The sum of future cash flows neglects the crucial aspect of discounting these values back to their present worth, making it incomplete for NPV analysis.

• The average return on investment is a performance