Thursday, January 21, 2010


Importance of the Net Present Value (NPV)

Net present value (NPV) is the true measure of an investment’s profitability. It provides the most acceptable investment rule for the following reasons:
  • Time value. It recognizes the time value of money-a $ received today is worth more than a $ received tomorrow.
  • Measure of true profitability. It uses all cash flows occurring over the entire life of the project in calculating its worth. Hence, it is a measure of the project’s true profitability. The net present value method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations.
  • Value additively. The discounting process facilitates measuring cash flows in terms of present values that is in terms of equivalent, current $. Therefore, the net present values of projects can be added. For example, NPV (A+B) =NPV (A) +NPV (B). This is called the value additively principle. It implies that if we know the net present values (NPV) of individual projects, the value of the firm will increases by the sum of their net present values (NPVs). We can also say that if we know values of individual assets, the firm’s value can simply be found by adding their values. The value additively is an important property of an investment criterion because it means that each project can be evaluated, independent of others, on its own merit.
  • Shareholder value. The net present value (NPV) method is always consistent with the objective of the shareholder value maximization. This is the greatest virtue of the method.

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