The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm.
Projects with a positive NPV are expected to increase the value of the firm.
NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.
The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (CF0).
Generally, If NPV> 0 (Zero). Accept the Project and if NPV< 0 (Zero). reject the Project.
Problem: Example of NPV calculation
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outflow (investment) will be $40,000. Calculate Net Present Value (@ 13%).
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cash Flow | -$40000 | $1000 | $12000 | $15000 | $10000 | $7000 |
Solutions:
= -$1424
As NPV is negative, i.g. NPV <0, so the project should be rejected. Company should not invest in this project.
Decision Rules
The NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected.
Generally, If NPV> 0 (Zero). Accept the Project and if NPV< 0 (Zero). reject the Project.
