Net Present Value

NET PRESENT VALUE

Firms generally have many investment opportunities available . Some of these investment opportunities are valuable and others are not . The essence of successful financial management is identifying which opportunities will increase shareholder wealth . There are three basic and related concepts that form the very foundation of modern day finance : present value , net present value (NPV ) and opportunity cost Present value gives the value of cash flows generated by an investment and NPV gives the effective net benefit from an investment after subtracting its costs . Opportunity cost represents the rate

of return on investments of comparable risk . Application of these concepts enables us to value different kinds of assets , especially those which are not commonly traded in well-functioning markets

NPV of an asset or investment is the present value of its cash flows less the cost of acquiring the asset . Smart investors will only acquire assets that have positive NPVs and will attempt to maximize the NPV of their investments . The rate of return received from an investment is the profit divided by the cost of the investment . Positive NPV investments will have rates of return higher than the opportunity cost . This gives an alternate investment decision rule . Good investments are those that have rates of return higher than the opportunity cost . This opportunity cost can be inferred from the capital market and is based on its risk characteristics of the investment

To assess why Net Present Value leads to better investment decisions than other criteria , let us start with a review of the NPV approach to investment decision making and then present four other widely used measures . These are : the payback period , the book rate of return , the internal rate of return (IRR ) and profitability index . The measures are inferior to the NPV and should not , with the qualified exception of the IRR , normally be relied upon to provide sound investment decisions These measures are commonly used in practice

The NPV represents the value added to the business by the project or the investment . It represents the increase in the market value of the stockholders ' wealth . Thus , accepting a project with a positive NPV will make the stockholders better off by the amount of its NPV . The NPV is the theoretically correct method to use in most situations . Other measures are inferior because they often give decisions different from those given by following the NPV rule . They will not serve the best interests of the stockholders (Brealey , 2002

To calculate NPV we should firstly forecast the incremental cash flows generated by the project and determine the appropriate discount rate which should be the opportunity cost of capital . Then calculate the sum of the present values (PV ) of all the cash flows generated by the investment . NPV PV of cash inflows - initial investment . To make decision on investment , we should accept projects with NPV greater than zero and for mutually exclusive projects , accept the project with the highest NPV , if the NPV is positive . The NPV represents the value...