Monday, January 18, 2010


Net Present Value Method (NPV)

The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is discounted cash flow technique that explicitly recognizes the tine value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present values are found out. The following steps involved in the calculation net present value (NPV):
  • Cash flows of the investment project should be forecast ed based on realistic assumptions.
  • Appropriate discount rate should be identified to discount the forecast ed cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk.
  • Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.
  • Net present value (NPV) should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if net present value (NPV) is positive.

Project acceptance rule using net present value

It should be clear that the acceptance rule using the net present value (NPV) method is to accept the investment project if its net present value (NPV) is positive and to reject it if the net present value (NPV) is negative. Positive net present value (NPV) contributes to the net wealth of the shareholders, which should result in the increased price of a firm’s share. The positive net present value (NPV) will result only if the project generates cash inflows at a rate higher than the opportunity cost of capital. A project with zero net present value (NPV) may be accepted. A zero net present value (NPV) implies that project generates cash flow at a rate just equal to the opportunity cost of capital.

The net present value (NPV) acceptance rules are:

  • Accept the project net present value (NPV) is positive
  • Reject the project net present value (NPV) is negative
  • May accept the project when net present (NPV) is zero

The net present value (NPV) can be used to select between mutually exclusive projects; the one with the higher net present value (NPV) should be selected. Using the net present value (NPV) method, projects would be ranked in order of net present values; that is, first rank will be given to the project with higher positive net present value (NPV) and so on.

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