Net Present Value
The term ‘Net Present Value’ (NPV) represents the difference between the present value of cash inflows and the present value of cash outflows for an investment. It is used when considering capital investments to assess profitability.
For an investment to be worthwhile it has to yield a positive NPV, meaning that profit will be generated over time as a result of the investment. A negative NPV indicates that the investment is likely to lose money. Like any other business investment, property development will aim to yield a positive NPV that is greater than would have been achieved if capital was invested elsewhere.
The formula for calculating NPV is as follows:
- Ct = net cash inflow during the period ‘t’
- Co = total initial investment costs
- r = discount rate
- t = number of time periods
A construction project has initial costs of £1.7m. It is expected to generate the following cash inflow:
- End of year 1 = £120,000.
- End of year 2 = £250,000.
- End of year 3 = £550,000.
- End of year 4 = £1.3m.
NPV = Benefits – Costs
NPV = £2.22m – £1.7m
NPV = £520,000
Without discounting there is sufficient economic justification for the project to go ahead.
Discounting is a way of comparing the value of costs and benefits over different time periods relative to their present values. Money is worth less in the future than it is in the present because of its reduced capacity for generating a return, such as interest, and because of inflation. Discounting is a means of assessing how much less an amount is worth in the future than it is now.
As property development and construction generally face significant costs over long periods of time, they are particularly susceptible to discount rate sensitivity.
With a 5% discount rate applied to the example project, the NPV becomes:
(Y1) £114,285.70 + (Y2) £226,757.37 + (Y3) £475,110.68 + (Y4) £1,069,513.22
NPV = £1,885,666.97
NPV = 1,885,666.97 – £1.7m
NPV = £185,666.97
So there is still economic justification for the project to go ahead. However, if the discount rate is increased to 10% the NPV is:
(Y1) £109,090.91 + (Y2) £206,611.57 + (Y3) £413,223.14 + (Y4) £887,917.49
NPV = £1,616,843.11
NPV = £1,616,843.11 – £1.7m
NPV = -£83,156.89
In this scenario there appears not to be economic justification for the project to go ahead.
As an analysis tool, NPV has a number of drawbacks:
- Estimated cash flows seldom match those experienced in practice.
- Given the incremental cost of capital required to fund a project, a simple discount rate may not adequately represent the situation.
- Adjustments to take account of risks will only be very rough estimate estimates.
- NPV analysis only considers the circumstances of a specific investment.
 Related articles on Designing Buildings Wiki
- Base year.
- Business plan.
- Capital allowances.
- Capital costs for construction projects.
- Cash flow.
- Compound Annual Growth Rate (CAGR).
- Cost performance index (CPI).
- Development appraisal.
- Discounted cash flow.
- Gross value added (GVA).
- Internal rate of return for property development.
- Life cycle assessment.
- Life Cycle Costing BG67 2016.
- Whole life costs.
 External references
Featured articles and news
Read about the launch event for our major new report about the worrying and widening construction knowledge gap.
We've analysed 6 million pieces of data to reveal that the knowledge framework underpinning the construction industry is no longer fit for purpose.
The theme for BSRIA's 2017 Briefing is 'Solutions to Tomorrow’s Challenges in Today’s Buildings'.
Dealing more than 1,700 consultations was just one of last year’s tasks for the Gardens Trust.
Read about the history behind one of California's most iconic buildings, the Griffith Observatory.
ICE examine just how close we are to providing subsidy-free low carbon electricity.
Have a look at MAD Architects' design proposal for renovating Montparnasse Tower into a concave mirror.
This article examines the legal issues behind off-site goods and materials.
Read about how technology is changing the real estate industry.
BRE Global introduce the first registration scheme for Suitably Qualified Security Specialists.
An introductory article to the different types of building foundations.
This unique Brutalist-era car park just off Oxford Street is soon to be demolished.