Complete Guide To Corporate Finance

AAA

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.

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. 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 ...
  2. Fundamental Analysis

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  3. 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.
  4. Professionals

    Net Present Value and the Internal Rate of Return

    CFA Level 1 - Discounted Cash Flow Applications - Basics
  5. Professionals

    Introduction To Net Present Value And Internal Rate Of Return

    These valuation methods will help you make investing decisions.
  6. Professionals

    Advantages And Disadvantages Of NPV and IRR

    Find out how to decide when to use these two methods, and when to avoid them.
  7. 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 ...
  8. 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.
  9. 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 ...
  10. 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.
RELATED TERMS
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  2. Net Present Value Rule

    A rule stating that an investment should be accepted if its net ...
  3. Profitability Index Rule

    A regulation for evaluating whether to proceed with a project ...
  4. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  5. Retained Cash Flow - RCP

    A measure of the net change in cash and cash equivalent assets ...
  6. Adjusted Present Value - APV

    The Net Present Value (NPV) of a project if financed solely by ...
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. What are the disadvantages of using net present value as an investment criterion?

    While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no ... Read Answer >>
  5. What is the formula for calculating net present value (NPV)?

    Learn about the formula for net present value (NPV) and how this calculation is used in capital budgeting to determine which ... Read Answer >>
  6. 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 >>

You May Also Like

Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  4. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  5. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  6. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
Trading Center