Discounted cash flow method: net present value (NPV) — FAQ

Not necessarily. NPV is a forecast, not a guarantee. A positive NPV indicates that if the forecasted cash flows and discount rate are accurate, the project is expected to generate returns exceeding its cost of capital, thereby adding value. However, the actual cash flows may differ from the forecast, and the project could still end up being unprofitable in reality. It is a tool for decision-making under uncertainty, not a prediction of a certain future.

Simply adding up cash flows ignores the time value of money. A £100 inflow in Year 5 is not worth the same as a £100 inflow in Year 1. Discounting provides a more realistic valuation by translating all future cash flows into their equivalent value today. This allows for a like-for-like comparison and accounts for the opportunity cost and risk associated with waiting for future returns. Methods that just add up cash flows, like payback, fail to capture this crucial financial concept.

Choosing the discount rate is a critical and challenging step. It is not entirely subjective, but it does involve judgement. Commonly, businesses use their Weighted Average Cost of Capital (WACC), which is the average rate of interest the company pays to finance its assets. Alternatively, they might use the interest rate on a risk-free investment (like government bonds) plus a 'risk premium' to compensate for the specific risks of the project. The chosen rate reflects the minimum acceptable return for the business on an investment of that risk level.