How is the net present value (NPV) calculated?

The net present value (NPV) is a crucial concept in financial management used to assess the profitability of an investment. The correct calculation of NPV involves determining the present value of future cash flows generated by the investment and then subtracting the initial investment cost.

The formula for NPV can be articulated as follows: the present value of expected cash inflows (which are discounted at a specified rate, commonly referred to as 'r') is computed for each period over the investment's lifespan. The summation of these discounted cash flows is then reduced by the amount of capital initially invested. This is why the selected formula correctly states that NPV equals the sum of the cash flows divided by (1 + r) raised to the power of t, minus the initial investment.

Thus, the proper calculation method accounted for time value of money principles, reflecting the decreased value of future cash flows due to factors such as inflation and risk over time. This technique helps investors determine whether the future earnings from an investment will outweigh the initial costs, ultimately guiding their financial decisions.