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.