Net Present Value (NPV)

NPV is rooted in the principle that a dollar today is worth more than a dollar tomorrow. This is because today's dollar can be invested to earn a return. The discount rate used in NPV reflects the opportunity cost of capital — the return you could earn on an alternative investment of similar risk. In corporate finance, this discount rate is typically WACC. In private equity, it's the fund's required return (usually 20–25%). The higher the discount rate, the lower the NPV.

Accept any project with NPV > 0 and reject any project with NPV < 0. When comparing mutually exclusive projects, choose the one with the highest NPV. This rule is superior to IRR in most cases because NPV measures absolute value creation in dollars, while IRR only measures percentage return. A project that costs $100M and has an IRR of 15% creates more value than a project that costs $1M with an IRR of 50%, assuming the cost of capital is 10%.

NPV and IRR usually agree on accept/reject decisions, but they can conflict when comparing projects of different sizes or timing. NPV is generally preferred because it avoids the problems of multiple IRRs (which occur with non-conventional cash flows) and the reinvestment rate assumption (IRR assumes intermediate cash flows are reinvested at the IRR, while NPV assumes reinvestment at WACC — a more realistic assumption). That said, PE professionals favor IRR because fund returns are measured as IRRs.

In investment banking, NPV underpins the DCF valuation methodology. The enterprise value in a DCF is simply the NPV of projected free cash flows plus terminal value. In corporate finance, companies use NPV to evaluate capital budgeting decisions — should we build a new factory? Acquire a competitor? Launch a new product? In each case, you project the incremental cash flows, discount at WACC, and check if NPV is positive.