Net Present Value Rule

Loading the player...

What is a 'Net Present Value Rule'

The net present value rule, a logical outgrowth of net present value theory, refers to the idea that company managers or investors should only invest in projects or engage in transactions that have a positive net present value (NPV), and should avoid investing in projects that have a negative net present value. According to the net present value rule theory, investing in something that has a net present value greater than zero should logically increase a company's earnings; or in the case of an investor, increase a shareholder's wealth.

BREAKING DOWN 'Net Present Value Rule'

Although most companies generally follow the net present value rule, there are occasional circumstances that require them to depart from it. For example, a company with significant debt issues may have to abandon or postpone undertaking a project with a positive NPV, instead committing its capital to resolving the immediately pressing debt issue. A company may disregard the net present value rule if it purposely chooses to engage in a project with a negative NPV in order to create an illusion for shareholders that the company is engaged in continuously ongoing corporate investment. There is also the possibility that a company's poor corporate governance leads it to ignore net present value theory.

Understanding Net Present Value

Net present value is a commonly used metric in capital budgeting that accounts for the time value of money, which is the idea that future dollars have less value than presently held dollars. It is a discounted cash flow calculation that reflects the potential change in wealth resulting from an undertaking, factoring in the time value of money by discounting projected cash flows back to the present, using a company's weighted average cost of capital (WACC). A project or investment's NPV equals the present value of net cash inflows that the project is expected to generate, minus the initial required investment for the project.

Using the Net Present Value Rule

A company uses the NPV calculation and applies the net present value rule in the decision-making process to evaluate whether or not a particular project, such as an acquisition, is worth the required investment.

If the calculated NPV of a project is negative, less than zero, then the project is expected to result in a net loss for the company, and the net present value rule tells the company to avoid the undertaking. If a project's NPV is positive, greater than zero, then the net present value rule says to go ahead with the project, as the investment should result in a net gain in profitability and value for the company.

In the event that a project's NPV is neutral, zero, then the project is not expected to result in any significant monetary gain or loss for the company. With a neutral NPV, company management then makes a decision based on non-monetary factors, such as possible goodwill, convenience or employee satisfaction benefits.

  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  2. Net Present Value Of Growth Opportunities ...

    A calculation of the net present value of all future cash flows ...
  3. Adjusted Present Value - APV

    The Net Present Value (NPV) of a project if financed solely by ...
  4. Profitability Index

    An index that attempts to identify the relationship between the ...
  5. Embedded Value

    A common valuation measure used outside North America, particularly ...
  6. Initial Cash Flow

    The amount of money paid out or received at the start of a project ...
Related Articles
  1. Financial Advisor

    What's a Hurdle Rate?

    Hurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ...
  2. Investing

    Understanding Net Present Value

    Learn how this value is used to determine the worth of a project.
  3. Investing

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  4. Trading

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  5. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  6. Investing

    Understanding The Time Value Of Money

    Find out why time really is money by learning to calculate present and future value.
  7. Investing

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  8. Investing

    Calculating Net Cash

    A company’s net cash is its total cash remaining after it subtracts all liabilities.
  9. Markets

    Calculating the Present Value of an Annuity

    The present value of an annuity is the current, lump sum value of periodic future payments as calculated using a specific rate.
  10. Investing

    An Introduction to Capital Budgeting

    Firms use capital budgeting to determine if a project, like building a new plant or developing a new product, is worth pursuing.
  1. How do you use net present value to calculate a capital budget?

    Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >>
  2. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  3. What is the formula for calculating net present value (NPV) in Excel?

    Understand how net present value is used to estimate the anticipated profitability of projects or investments and how to ... Read Answer >>
  4. What is the difference between present value and net present value?

    Understand the difference between the present value and net present value calculations and how these formulas are used in ... Read Answer >>
  5. How much debt is too much when calculating capital budgeting?

    Learn how companies determine how much debt is acceptable when funding a new project by using the net present value to estimate ... Read Answer >>
  6. What's the difference between net present value and internal rate of return? How ...

    Both of these measurements are primarily used in capital budgeting, the process by which companies determine whether a new ... Read Answer >>
Hot Definitions
  1. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  2. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  3. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  4. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  5. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  6. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
Trading Center