Complete Guide To Corporate Finance


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 after-tax 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.

Year 0
Year 1
Year 2
Year 3
Year 4
Year 5

Year 0
Year 1
Year 2
Year 3
Year 4
Year 5

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 value-added 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 after-tax cash flows for the new machines

Calculation and Answer:
NPVA = -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

NPVB = -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 NPVB > NPVA, Newco should choose the project for Machine B.

We'll discuss additional applications of NPV in the following pages.

Payback Rule
Related Articles
  1. Budgeting

    Your Worst Financial Mistakes And Why You Made Them

    No one intends to make a financial mistake, but an unexpected disaster or poor planning could leave you in financial distress.
  2. Bonds & Fixed Income

    An Assessment of High Yield Corporate Bond Credit Spreads

    A credit risk literature review.
  3. Personal Finance

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  4. Investing

    Is it Time to “Buy” Inflation?

    Based on recent data from the Treasury-Inflation Protected Securities (TIPS) market, it would seem that most investors aren’t worried about inflation.
  5. Economics

    Explaining Appreciation

    Appreciation refers to an increase over time in the value of an investment or asset.
  6. Economics

    Calculating Long-Term Debt to Total Assets Ratio

    A company’s long-term debt to total assets ratio shows the percentage of its assets that are financed with long-term debt.
  7. Economics

    Explaining Like-for-Like Sales

    Companies use like-for-like sales figures to compare sales volume from one period to another.
  8. Investing

    How Worried Should We Be About China?

    An economic slowdown, a freezing up in trade and plunging markets and currencies are casting a shadow across Asia—and the globe. How worried should we be?
  9. Technical Indicators

    Explaining Autocorrelation

    Autocorrelation is the measure of an internal correlation with a given time series.
  10. Term

    Public Goods & Free Riders

    A public good is an item whose consumption is determined by society, not individual consumers.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Encumbrance

    A claim against a property by a party that is not the owner. ...
  3. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Linear Relationship

    A statistical term used to describe the directly proportional ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. Do dividends affect working capital?

    Regardless of whether cash dividends are paid or accrued, a company's working capital is reduced. When cash dividends are ... Read Full Answer >>
  6. Do prepayments provide working capital?

    Prepayments, or prepaid expenses, are typically included in the current assets on a company's balance sheet, as they represent ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!