Describe the concept of net present value (NPV).

Net Present Value (NPV) is a fundamental concept used in capital budgeting and investment analysis that seeks to determine the value of an investment by analyzing the present value of expected cash inflows and outflows over a specific period. The correct choice clearly states that NPV is calculated by taking the present value of cash inflows and subtracting the present value of cash outflows.

This measure is crucial because cash flows occurring at different times cannot be simply added or subtracted due to the time value of money—the idea that money available at the present time has a higher value than the same amount in the future because of its potential earning capacity. Thus, to arrive at NPV, one applies a discount rate to future cash flows to reflect their present value, allowing for a meaningful assessment of the investment's worth. If the NPV is positive, it suggests that the projected earnings (in present dollars) exceed the anticipated costs, indicating a potentially good investment.

Understanding NPV helps investors evaluate investment decisions by providing a clearer financial picture of expected returns, rather than just considering revenues or expenses in isolation or based solely on future projections without discounting them to present value.