The net present value (NPV) is a financial metric used to assess the profitability of an investment. A negative NPV indicates that the present value of future cash flows generated by the investment is less than the initial cost of the investment.
In other words, a negative NPV suggests that the investment is not expected to generate enough cash flow to cover the initial investment cost and provide a return that exceeds the required rate of return.
Here's an example to help illustrate this concept:
Let's say you are considering investing $10,000 in a project that is expected to generate cash flows of $3,000 per year for the next 5 years. To calculate the NPV, you would discount each future cash flow to its present value by using a discount rate (usually the required rate of return).
If the discount rate is 10%, the present value of the cash flows would be calculated as follows:
Year 1: $3,000 / (1 + 0.10)^1 = $2,727.27
Year 2: $3,000 / (1 + 0.10)^2 = $2,479.34
Year 3: $3,000 / (1 + 0.10)^3 = $2,263.04
Year 4: $3,000 / (1 + 0.10)^4 = $2,074.58
Year 5: $3,000 / (1 + 0.10)^5 = $1,910.53
The total present value of the cash flows would be $2,727.27 + $2,479.34 + $2,263.04 + $2,074.58 + $1,910.53 = $11,454.76
Since the initial investment cost is $10,000, the NPV would be $11,454.76 - $10,000 = $1,454.76, which is positive. This indicates that the investment is expected to generate a return that exceeds the required rate of return.
However, if the NPV were negative (e.g., -$500), it would suggest that the investment is not expected to generate enough cash flow to cover the initial investment cost and provide a return that exceeds the required rate of return. In this case, the investment may not be considered financially viable.