NET PRESENT VALUE (NPV)

Net present value (NPV)

- is a sophisticated capital budgeting technique; found by subtracting a project’s initial

investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost

of capital.

- is found by subtracting a project’s initial investment from the present value of its cash

inflows discounted at a rate equal to the firm’s cost of capital .

- are used to determine whether a project or investment is worth doing by comparing

initial investment and the total value of future.

NPV = Present value of cash inflows – Initial investment

Decision criteria:

– If the NPV is greater than $0, accept the project.

– If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such

action should increase the market value of the firm, and therefore the wealth of its owners by an

amount equal to the NPV.

Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives

We can illustrate the net present value (NPV) approach by using Bennett Company data . If the

firm has a 10% cost of capital, the net present values for projects A (an annuity) and B (a mixed

stream) can be calculated as shown on the time lines in Figure 10.2 These calculations result in

net present values for projects A and B of $11,071 and $10,924, respectively. Both projects are

acceptable, because the net present value of each is greater than $0. If the projects were being

ranked,

however,

project A

would be

considered

superior to B,

because it has a

higher net

present value

than that of B

($11,071

versus $10,924).
Spreadsheet Use The NPVs can be calculated as shown on the following Excel spreadsheet.