How is Net Present Value (NPV) calculated?

Net Present Value (NPV) is calculated by determining the present value of expected future cash flows generated by an investment and subtracting the initial investment cost. This method takes into account the time value of money, which recognizes that a dollar received in the future is worth less than a dollar received today due to its potential earning capacity.

To derive the NPV, future cash flows are discounted back to their present value using an appropriate discount rate, typically representing the cost of capital or the required rate of return. The sum of these present values is then reduced by the initial investment cost to arrive at the NPV. A positive NPV indicates that the investment is expected to generate more wealth than the cost of the capital used, making it a desirable project, while a negative NPV signifies the opposite.

The other options do not accurately reflect the NPV calculation methodology. The first option simplifies the process by failing to account for the discounting of future cash flows. The third choice focuses solely on revenues and costs without considering the significance of time value and present value adjustment. The last option incorrectly suggests a calculations method based on multiplying revenues and the cost of equity, which is not relevant to NPV determination.