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.

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 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. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  2. Managing Wealth

    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 ...
  3. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  4. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
  5. Personal Finance

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
  6. Small Business

    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.
  7. Personal Finance

    Project Manager: Career Path & Qualifications

    Learn more about what project managers job, the qualifications necessary for the position and the most common careers for these professionals.
  8. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  9. Investing

    Internal Rate of Return Formula for Excel

    The internal rate of return, or IRR, is a popular metric businesses use to measure a project’s return on investment.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center