Investment Appraisal: Net Present Value

The payback period and ARR are useful but fundamentally flawed because they ignore the time value of money. A pound received today is worth more than a pound received in five years' time — because today's pound can be invested to earn a return, and because inflation erodes the purchasing power of future money. Net present value (NPV) addresses this weakness by discounting future cash flows to their present-day value. NPV is widely regarded as the most theoretically sound method of investment appraisal.

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The Time Value of Money

The concept is straightforward: money received sooner is worth more than the same amount received later. There are three reasons for this:

Reason	Explanation
Opportunity cost	Money received today can be invested to earn a return — delaying receipt means forgoing that return
Inflation	Rising prices reduce the purchasing power of future money — £100 in five years will buy less than £100 today
Risk	The further into the future a cash flow falls, the greater the uncertainty that it will actually materialise

Example