Net Present Value NPV

The net present value (NPV) method is a sophisticated capital budgeting technique that equates the discounted cash flows against the initial investment.

Mathematically,

- El where FV is the future value of the cash inflows, II represents the initial investment, and k is the discount rate equal to the firm's cost of capital.

Table 14-16 calculates the NPV for the data provided previously in Table 14-15 using a discount rate of 10%.

TABLE 14-16. NPV CALCULATION FOR PROJECT A

Year

Cash Inflows

2,000

2,000

5,000

2,000

Present value of cash inflows

Less investment

Present Value

Net Present Value

This indicates that the cash inflows discounted to the present will not recover the initial investment. This, in fact, is a bad investment to consider. Previously, we stated that the cash flow stream yielded a payback period of four years. However, using discounted cash flow, the actual payback is greater than five years, assuming that there will be cash inflow in years 6 and 7.

If in Table 14-16 the initial investment was $5,000, then the net present value would be $3,722. The decision-making criteria using NPV are as follows:

• If the NPV is greater than or equal to zero dollars, accept the project.

• If the NPV is less than zero dollars, reject the project.

A positive value of NPV indicates that the firm will earn a return equal to or greater than its cost of capital.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

Get My Free Ebook


Post a comment