understanding Net Present Value (NPV)

Stuart Patch
Oct 1
2 min read

— A Key Step in Cost-Benefit Analysis

Following on from my recent post on the 7 key steps to develop a Cost-Benefit Analysis (CBA), step 5 referred assessing net benefit of each option. One of the most useful tools for this is Net Present Value (NPV).

NPV helps us evaluate whether a proposals benefits outweigh its costs by converting future cash flows into today’s dollars. This reflects the time value of money, allowing us to compare different proposals with varying cash flows on a consistent basis.

🔍 Example:

Imagine a project that costs $100,000 today and is expected to generate $30,000 per year for 4 years.

At first glance, the total benefits of $120,000 (4 years at $30,000) exceed the cost of $100,000, which seems promising.

If we take into account the time value of money and apply a discount rate of 8%, the cost remains the same as it happens this year. The benefits however reduce to $99,364 which results in a small negative NPV of 636 suggesting the proposal may not be financially sound.

(See the image below for the calculation.)

What is the discount rate?

The discount rate is there to represent the opportunity cost of capital or in other words, the minimum expected return for the organisation.

In the Public Sector a social discount rate is often published by treasury,
In commercial enterprises, organisations typically use the weighted average cost of capital (WACC).

💡 Why does an NPV calculation matter?

In any CBA, it’s essential to consider financial costs and benefits. NPV provides a clear picture of economic impact and helps decision-makers allocate resources to proposals that deliver real value. It also enables comparison between alternatives to identify the most viable option.

What about non-financial costs and benefits?

To fully understand a proposal’s value, we must also consider non-financial impacts, such as, improved health outcomes or community satisfaction. Ideally, these are translated into financial terms for inclusion in the NPV. However, for smaller proposals, they may be described qualitatively rather than quantified.

🔍 NPV in a Nutshell

Net Present Value (NPV) is a key tool in Cost-Benefit Analysis that helps determine whether a proposal’s future benefits outweigh its costs, by converting future cash flows into today’s dollars.

Why it matters: It accounts for the time value of money, enabling fair comparison between options.
How it works: Apply a discount rate to future cash flows to calculate their present value.
What it shows: A positive NPV means the proposal adds financial value; a negative NPV suggests it may not be viable.

NPV helps ensure resources are invested in projects that deliver real economic impact and when combined with non-financial analysis, it supports well-rounded decision-making.