
Net Present Value And Internal Rate Of Return  Net Present Value
The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the aftertax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives. The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.
In the two examples below, assuming a discount rate of 10%, project A and project B have respective NPVs of $126,000 and $1,200,000. These results signal that both capital budgeting projects would increase the value of the firm, but if the company only has $1 million to invest at the moment, project B is superior.
Investment 
Inflows 

Year 0 
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 
1,000,000 
300,000 
300,000 
300,000 
300,000 
300,000 
Investment 
Inflows 

Year 0 
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 
1,000,000 
300,000 
300,000 
300,000 
300,000 
3,000,000 
Some of the major advantages of the NPV approach include the overall usefulness and easy understandability of the figure. NPV provides a direct measure of added profitability, allowing one to simultaneously compare multiple mutually exclusive projects and even though the discount rate it subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns. Although the NPV approach is subject to fair criticisms that the valueadded figure does not factor in the overall magnitude of the project, the profitability index (PI), a metric derived from discounted cash flow calculations, can easily fix this concern. We'll discuss the profitability index in a later section. (It's never too early to start learning about money. Read 5 Ways To Teach Your Kids The Value Of A Dollar.)
Here is another example of how companies use NPV.
Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows minus the original investment.
Projects with NPV > 0 increase stockholders\' return Projects with NPV < 0 decrease stockholders\' return 
Example: Net Present Value
Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity to its existing plant. Using the cash flows in the table below, let's calculate the NPV for each machine and decide which project Newco should accept. Assume Newco's cost of capital is 8.4%.
Expected aftertax cash flows for the new machines
Calculation and Answer:
NPV_{A} = 5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)^{1} (1.084)^{2} (1.084)^{3} (1.084)^{4} (1.084)^{5} (1.084)^{6}NPV_{B} = 2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929
(1.084)^{1} (1.084)^{2} (1.084)^{3} (1.084)^{4} (1.084)^{5} (1.084)^{6}
Given that both machines have NPV > 0, both projects are acceptable. However, for mutually exclusive projects, the decision rule is to choose the project with the greatest NPV. Since the NPV_{B} > NPV_{A}, Newco should choose the project for Machine B.
We'll discuss additional applications of NPV in the following pages.


Professionals
Net Present Value (NPV) and the Internal Rate of Return (IRR)
CFA Level 1  Net Present Value (NPV) and the Internal Rate of Return (IRR). Learn how to calculate net present value and internal rate of return. Provides samples highlighting the relationship ... 
Fundamental Analysis
Calculating Net Present Value at Different Points Using Excel
Calculating the net present value (NPV) of your investment projects using Excel. 
Professionals
The NPV Profile
CFA Level 1  The NPV Profile. Learn how firms can compare projects using an NPV profile graph. Provides a graphical example of how NPV relates to IRR. 
Professionals
Net Present Value and the Internal Rate of Return
CFA Level 1  Discounted Cash Flow Applications  Basics 
Professionals
Introduction To Net Present Value And Internal Rate Of Return
These valuation methods will help you make investing decisions. 
Professionals
Advantages And Disadvantages Of NPV and IRR
Find out how to decide when to use these two methods, and when to avoid them. 
Professionals
Advantages and Disadvantages of the NPV and IRR Methods
CFA Level 1  Advantages and Disadvantages of the NPV and IRR Methods. Learn the advantages and disadvantages to the NPV and IRR valuation methods. Explains why these two methods can offer conflicting ... 
Professionals
Comparing Projects With Unequal Lives
CFA Level 1  Comparing Projects With Unequal Lives. Learn how comparing projects with unequal lives can offer conflicting NPV and IRR results. Offers two methods to remedy the problem. 
Investing Basics
Capital Budgeting: Capital Budgeting Decision Tools
Once projects have been identified, management then begins the financial process of determining whether or not the project should be pursued. The three common capital budgeting decision tools ... 
Economics
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.

Net Present Value  NPV
Net Present Value (NPV) is the difference between the present ... 
Net Present Value Rule
A rule stating that an investment should be accepted if its net ... 
Profitability Index Rule
A regulation for evaluating whether to proceed with a project ... 
Discounted Payback Period
A capital budgeting procedure used to determine the profitability ... 
Retained Cash Flow  RCP
A measure of the net change in cash and cash equivalent assets ... 
Adjusted Present Value  APV
The Net Present Value (NPV) of a project if financed solely by ...

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