The net present value (NPV) method of capital investment appraisal is based on the view that a project will be regarded as successful if the present value of all expected cash inflows is greater than, or equal to, the capital invested at the outset. It is called net present value because, in calculation, the capital invested is deducted from the present value of the future cash flows. (Use of the word ‘net’ always means that one item is being deducted from another.) If the present value of the expected cash flows is greater than the capital invested, then the net present value will be positive. If the present value of the expected cash flows is less than the capital invested, then the net present value will be negative. A positive net present value indicates that the project should be accepted, while a negative net present value indicates that it should be rejected.
The net present value of a project is equal to the present value of the cash inflows minus the present value of the cash outflows, all discounted at the cost of capital.
Cash flows are calculated as profit before deducting depreciation and amortization.
The NPV decision rule is as follows:
1 Where the net present value of the project is positive, accept the project.
2 Where the net present value of the project is negative, reject the project.
3 Where the net present value of the project is zero, the project is acceptable in meeting the cost of capital but gives no surplus to its owners.
If an organization seeks to maximize the wealth of its owners, then it should accept any project which has a positive net present value. If finance markets are working efficiently, funds will always be available to finance projects which meet or exceed their cost of capital.
Net Present Value (NPV) and the Internal Rate of Return (IRR)
Net Present Value
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
Using the cash flows in the previous examples, calculate the NPV for each machine and decide which project Newco should accept. As calculated previously, Newco's cost of capital is 8.4%.
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.
Internal Rate of Return
The internal rate of return (IRR) on a project is the rate of return at which the projects NPV equals zero. At this point, a project's cash flows are equal to the project's costs. Similar to how management must establish a maximum payback period, management must also set what is known as a "hurdle rate", the minimum rate of return a company will accept for a project.
When a project is reviewed with a hurdle rate in mind, the greater the IRR is above the hurdle rate, the greater the NPV, and conversely, the further the IRR is below the hurdle rate, the lower the NPV.
For the IRR, the decision rules are as follows:
If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject