The net present value method focuses on how much money our investment is going to generate using the time value of money. For example, we invested $100,000 and it creates $25,000 of cash flow per year for 10 years. But we can’t just say that it produces $250,000 of cash flows because we have to use the present value of the $250,000.

Let’s say that we want to generate a 10% return on this investment. Meaning that 10% is our hurdle rate, the amount that we want. We’re going to use this hurdle rate of 10% as our discount rate for figuring out the present value.

We need to find the present value of these $25,000 payments (ordinary annuity). The present value factor for an ordinary annuity at 10% for 10 years is 6.144. We multiply the $25,000 of annual cash flows by the factor of 6.144, which is $153,600. That means that the present value of all of these payments of $25,000 is $153,600.

Net Present Value = Present Value of Cash Inflows – Initial Investment

We know here that our present value of cash inflows is $153,600, and our initial investmentwas $100,000. Our net present value of this investment is $53,600. This means that we’re going to generate $53,600 from our investment.

If the net present value is positive, then we accept the decision because it means it’s going to make us money. If the net present value is negative, then we reject the decision because that would mean that we would lose money.