Net present value

The net present value (NPV) or net present wor th (NPW)[1] is a way of measuring t he value of
an asset t hat has cashflow by adding up t he present value of all t he fut ure cash flows t hat asset
will generat e. The present value of a cash flow depends on t he int erval of t ime bet ween now and
t he cash flow because of t he Time value of money (which includes t he annual effect ive discount
rat e). It provides a met hod for evaluat ing and comparing capit al project s or financial product s
wit h cash flows spread over t ime, as in loans, invest ment s, payout s from insurance cont ract s plus
many ot her applicat ions.

Time value of money dict at es t hat t ime affect s t he value of cash flows. For example, a lender
may offer 99 cent s for t he promise of receiving $1.00 a mont h from now, but t he promise t o
receive t hat same dollar 20 years in t he fut ure would be wort h much less t oday t o t hat same
person (lender), even if t he payback in bot h cases was equally cert ain. This decrease in t he
current value of fut ure cash flows is based on a chosen rat e of ret urn (or discount rat e). If for
example t here exist s a t ime series of ident ical cash flows, t he cash flow in t he present is t he
most valuable, wit h each fut ure cash flow becoming less valuable t han t he previous cash flow. A
cash flow t oday is more valuable t han an ident ical cash flow in t he fut ure [2] because a present
flow can be invest ed immediat ely and begin earning ret urns, while a fut ure flow cannot .

NPV is det ermined by calculat ing t he cost s (negat ive cash flows) and benefit s (posit ive cash
flows) for each period of an invest ment . Aft er t he cash flow for each period is calculat ed, t he
present value (PV) of each one is achieved by discount ing it s fut ure value (see Formula) at a
periodic rat e of ret urn (t he rat e of ret urn dict at ed by t he market ). NPV is t he sum of all t he
discount ed fut ure cash flows.

Because of it s simplicit y, NPV is a useful t ool t o det ermine whet her a project or invest ment will
result in a net profit or a loss. A posit ive NPV result s in profit , while a negat ive NPV result s in a
loss. The NPV measures t he excess or short fall of cash flows, in present value t erms, above t he
cost of funds.[3] In a t heoret ical sit uat ion of unlimit ed capit al budget ing, a company should
pursue every invest ment wit h a posit ive NPV. However, in pract ical t erms a company's capit al
const raint s limit invest ment s t o project s wit h t he highest NPV whose cost cash flows, or init ial
cash invest ment , do not exceed t he company's capit al. NPV is a cent ral t ool in discount ed cash
flow (DCF) analysis and is a st andard met hod for using t he t ime value of money t o appraise long-
t erm project s. It is widely used t hroughout economics, financial analysis, and financial account ing.

In t he case when all fut ure cash flows are posit ive, or incoming (such as t he principal and coupon
payment of a bond) t he only out flow of cash is t he purchase price, t he NPV is simply t he PV of
fut ure cash flows minus t he purchase price (which is it s own PV). NPV can be described as t he
"difference amount " bet ween t he sums of discount ed cash inflows and cash out flows. It
compares t he present value of money t oday t o t he present value of money in t he fut ure, t aking
inflat ion and ret urns int o account .

The NPV of a sequence of cash flows t akes as input t he cash flows and a discount rat e or
discount curve and out put s a present value, which is t he current fair price. The converse process
in discount ed cash flow (DCF) analysis t akes a sequence of cash flows and a price as input and as
out put t he discount rat e, or int ernal rat e of ret urn (IRR) which would yield t he given price as NPV.
This rat e, called t he yield, is widely used in bond t rading.

Formula

Each cash inflow/out flow is discount ed back t o it s present value (PV). Then all are summed such
t hat NPV is t he sum of all t erms:

where:

t is t he t ime of t he cash flow

i is t he discount rat e, i.e. t he ret urn t hat could be earned per unit of t ime on an invest ment wit h
similar risk

is t he net cash flow i.e. cash inflow – cash out flow, at t ime t. For educat ional purposes,
is commonly placed t o t he left of t he sum t o emphasize it s role as (minus) t he invest ment .

is t he discount fact or, also known as t he present value fact or.

The result of t his formula is mult iplied wit h t he Annual Net cash in-flows and reduced by Init ial
Cash out lay t he present value, but in cases where t he cash flows are not equal in amount , t he
previous formula will be used t o det ermine t he present value of each cash flow separat ely. Any
cash flow wit hin 12 mont hs will not be discount ed for NPV purpose, nevert heless t he usual init ial
invest ment s during t he first year R0 are summed up a negat ive cash flow.[4]

The NPV can also be t hought of as t he difference bet ween t he discount ed benefit s and cost s
over t ime. As such, t he NPV can also be writ t en as:

where:

B are t he benefit s or cash inflows

C are t he cost s or cash out flows

Given t he (period, cash inflows, cash out flows) shown by (t, , ) where N is t he t ot al number
of periods, t he net present value is given by:
where:

are t he benefit s or cash inflows at t ime t.

are t he cost s or cash out flows at t ime t.

The NPV can be rewrit t en using t he net cash flow in each t ime period as:

By convent ion, t he init ial period occurs at t ime , where cash flows in successive periods are
t hen discount ed from and so on. Furt hermore, all fut ure cash flows during a period
are assumed t o be at t he end of each period.[5] For const ant cash flow R, t he net present value
is a finit e geomet ric series and is given by:

Inclusion of t he t erm is import ant in t he above formulae. A t ypical capit al project involves a
large negat ive cashflow (t he init ial invest ment ) wit h posit ive fut ure cashflows (t he ret urn on
t he invest ment ). A key assessment is whet her, for a given discount rat e, t he NPV is posit ive
(profit able) or negat ive (loss-making). The IRR is t he discount rat e for which t he NPV is exact ly 0.

Capital efficiency

The NPV met hod can be slight ly adjust ed t o calculat e how much money is cont ribut ed t o a
project 's invest ment per dollar invest ed. This is known as t he capit al efficiency rat io. The formula
for t he net present value per dollar invest ment (NPVI) is given below:

where:

is t he net cash flow i.e. cash inflow – cash out flow, at t ime t.

are t he net cash out flows, at t ime t.

Example

If t he discount ed benefit s across t he life of a project are $100 million and t he discount ed net
cost s across t he life of a project are $60 million t hen t he NPVI is:
$100M- $60M
NPVI= $60M
⁠≈ 0.6667

That is for every dollar invest ed in t he project , a cont ribut ion of $0.6667 is made t o t he project 's
NPV.[6]

Alternative discounting frequencies

The NPV formula assumes t hat t he benefit s and cost s occur at t he end of each period, result ing
in a more conservat ive NPV. However, it may be t hat t he cash inflows and out flows occur at t he
beginning of t he period or in t he middle of t he period.

The NPV formula for mid period discount ing is given by:

Over a project 's lifecycle, cash flows are t ypically spread across each period (for example spread
across each year), and as such t he middle of t he year represent s t he average point in t ime in
which t hese cash flows occur. Hence mid period discount ing t ypically provides a more accurat e,
alt hough less conservat ive NPV.[7][8] ЧикЙ The NPV formula using beginning of period discount ing
is given by:

This result s in t he least conservat ive NPV.

The discount rate

The rat e used t o discount fut ure cash flows t o t he present value is a key variable of t his process.

A firm's weight ed average cost of capit al (aft er t ax) is oft en used, but many people believe t hat
it is appropriat e t o use higher discount rat es t o adjust for risk, opport unit y cost , or ot her fact ors.
A variable discount rat e wit h higher rat es applied t o cash flows occurring furt her along t he t ime
span might be used t o reflect t he yield curve premium for long-t erm debt .

Anot her approach t o choosing t he discount rat e fact or is t o decide t he rat e which t he capit al
needed for t he project could ret urn if invest ed in an alt ernat ive vent ure. If, for example, t he
capit al required for Project A can earn 5% elsewhere, use t his discount rat e in t he NPV
calculat ion t o allow a direct comparison t o be made bet ween Project A and t he alt ernat ive.
Relat ed t o t his concept is t o use t he firm's reinvest ment rat e. Re-invest ment rat e can be defined
as t he rat e of ret urn for t he firm's invest ment s on average. When analyzing project s in a capit al
const rained environment , it may be appropriat e t o use t he reinvest ment rat e rat her t han t he firm's
weight ed average cost of capit al as t he discount fact or. It reflect s opport unit y cost of
invest ment , rat her t han t he possibly lower cost of capit al.

An NPV calculat ed using variable discount rat es (if t hey are known for t he durat ion of t he
invest ment ) may bet t er reflect t he sit uat ion t han one calculat ed from a const ant discount rat e
for t he ent ire invest ment durat ion. Refer t o t he t ut orial art icle writ t en by Samuel Baker[9] for
more det ailed relat ionship bet ween t he NPV and t he discount rat e.

For some professional invest ors, t heir invest ment funds are commit t ed t o t arget a specified rat e
of ret urn. In such cases, t hat rat e of ret urn should be select ed as t he discount rat e for t he NPV
calculat ion. In t his way, a direct comparison can be made bet ween t he profit abilit y of t he project
and t he desired rat e of ret urn.

To some ext ent , t he select ion of t he discount rat e is dependent on t he use t o which it will be
put . If t he int ent is simply t o det ermine whet her a project will add value t o t he company, using
t he firm's weight ed average cost of capit al may be appropriat e. If t rying t o decide bet ween
alt ernat ive invest ment s in order t o maximize t he value of t he firm, t he corporat e reinvest ment
rat e would probably be a bet t er choice.

Risk-adjusted net present value (rNPV)

Using variable rat es over t ime, or discount ing "guarant eed" cash flows different ly from "at risk"
cash flows, may be a superior met hodology but is seldom used in pract ice. Using t he discount
rat e t o adjust for risk is oft en difficult t o do in pract ice (especially int ernat ionally) and is difficult
t o do well.

An alt ernat ive t o using discount fact or t o adjust for risk is t o explicit ly correct t he cash flows for
t he risk element s using risk-adjust ed net present value (rNPV) or a similar met hod, t hen discount
at t he firm's rat e.

Use in decision making

NPV is an indicat or of how much value an invest ment or project adds t o t he firm. Wit h a part icular
project , if is a posit ive value, t he project is in t he st at us of posit ive cash inflow in t he t ime
of t. If is a negat ive value, t he project is in t he st at us of discount ed cash out flow in t he t ime
of t. Appropriat ely risked project s wit h a posit ive NPV could be accept ed. This does not
necessarily mean t hat t hey should be undert aken since NPV at t he cost of capit al may not
account for opport unit y cost , i.e., comparison wit h ot her available invest ment s. In financial t heory,
if t here is a choice bet ween t wo mut ually exclusive alt ernat ives, t he one yielding t he higher NPV
should be select ed. A posit ive net present value indicat es t hat t he project ed earnings generat ed
by a project or invest ment (in present dollars) exceeds t he ant icipat ed cost s (also in present
dollars). This concept is t he basis for t he Net Present Value Rule, which dict at es t hat t he only
invest ment s t hat should be made are t hose wit h posit ive NPVs.

An invest ment wit h a posit ive NPV is profit able, but one wit h a negat ive NPV will not necessarily
result in a net loss: it is just t hat t he int ernal rat e of ret urn of t he project falls below t he required
rat e of ret urn.

If... It means... Then...

the investment would add value to the

NPV > 0 the project may be accepted
firm

the investment would subtract value from

NPV < 0 the project may be rejected
the firm

We should be indifferent in the decision whether to

accept or reject the project. This project adds no
the investment would neither gain nor
NPV = 0 monetary value. Decision should be based on other
lose value for the firm
criteria, e.g., strategic positioning or other factors not
explicitly included in the calculation.

Advantages and disadvantages of using Net Present Value

NPV is an indicat or for project invest ment s, and has several advant ages and disadvant ages for
decision-making.

Advantages

The NPV includes all relevant t ime and cash flows for t he project by considering t he t ime value
of money, which is consist ent wit h t he goal of wealt h maximizat ion by creat ing t he highest
wealt h for shareholders.

The NPV formula account s for cash flow t iming pat t erns and size differences for each project ,
and provides an easy, unambiguous dollar value comparison of different invest ment opt ions.[10][11]

The NPV can be easily calculat ed using modern spreadsheet s, under t he assumpt ion t hat t he
discount rat e and fut ure cash flows are known. For a firm considering invest ing in mult iple
project s, t he NPV has t he benefit of being addit ive. That is, t he NPVs of different project s may
be aggregat ed t o calculat e t he highest wealt h creat ion, based on t he available capit al t hat can
be invest ed by a firm.[12]

Disadvantages

The NPV met hod has several disadvant ages.

The NPV approach does not consider hidden cost s and project size. Thus, invest ment decisions
on project s wit h subst ant ial hidden cost s may not be accurat e.[13]

Relies on input parameters such as knowledge of future cash flows

The NPV is heavily dependent on knowledge of fut ure cash flows, t heir t iming, t he lengt h of a
project , t he init ial invest ment required, and t he discount rat e. Hence, it can only be accurat e if
t hese input paramet ers are correct ; alt hough, sensit ivit y analyzes can be undert aken t o examine
how t he NPV changes as t he input variables are changed, t hus reducing t he uncert aint y of t he
NPV.[14]

Relies on choice of discount rate and discount factor

The accuracy of t he NPV met hod relies heavily on t he choice of a discount rat e and hence
discount fact or, represent ing an invest ment 's t rue risk premium.[15] The discount rat e is assumed
t o be const ant over t he life of an invest ment ; however, discount rat es can change over t ime. For
example, discount rat es can change as t he cost of capit al changes.[16][10] There are ot her
drawbacks t o t he NPV met hod, such as t he fact t hat it displays a lack of considerat ion for a
project ’s size and t he cost of capit al.[17][11]

Lack of consideration of non-financial metrics

The NPV calculat ion is purely financial and t hus does not consider non-financial met rics t hat may
be relevant t o an invest ment decision.[18]

Difficulty in comparing mutually exclusive projects

Comparing mut ually exclusive project s wit h different invest ment horizons can be difficult . Since
unequal project s are all assumed t o have duplicat e invest ment horizons, t he NPV approach can
be used t o compare t he opt imal durat ion NPV.[19]

Interpretation as integral transform

The t ime-discret e formula of t he net present value

can also be writ t en in a cont inuous variat ion

where

r(t) is t he rat e of flowing cash given in money per t ime, and r(t) = 0 when t he invest ment is over.

Net present value can be regarded as Laplace- [20][21] respect ively Z-t ransformed cash flow wit h
t he int egral operat or including t he complex number s which resembles t o t he int erest rat e i from
t he real number space or more precisely s = ln(1 + i).

From t his follow simplificat ions known from cybernet ics, cont rol t heory and syst em dynamics.
Imaginary part s of t he complex number s describe t he oscillat ing behaviour (compare wit h t he
pork cycle, cobweb t heorem, and phase shift bet ween commodit y price and supply offer)
whereas real part s are responsible for represent ing t he effect of compound int erest (compare
wit h damping).

Example

A corporat ion must decide whet her t o int roduce a new product line. The company will have
immediat e cost s of 100,000 at t = 0. Recall, a cost is a negat ive for out going cash flow, t hus t his
cash flow is represent ed as −100,000. The company assumes t he product will provide equal
benefit s of 10,000 for each of 12 years beginning at t = 1. For simplicit y, assume t he company will
have no out going cash flows aft er t he init ial 100,000 cost . This also makes t he simplifying
assumpt ion t hat t he net cash received or paid is lumped int o a single t ransact ion occurring on the
last day of each year. At t he end of t he 12 years t he product no longer provides any cash flow
and is discont inued wit hout any addit ional cost s. Assume t hat t he effect ive annual discount rat e
is 10%.

The present value (value at t = 0) can be calculat ed for each year:

Year Cash flow Present value

T=0 −100,000

T=1 9,090.91

T=2 8,264.46

T=3 7,513.15

T=4 6,830.13

T=5 6,209.21

T=6 5,644.74

T=7 5,131.58

T=8 4,665.07

T=9 4,240.98

T = 10 3,855.43

T = 11 3,504.94

T = 12 3,186.31

The t ot al present value of t he incoming cash flows is 68,136.91. The t ot al present value of t he
out going cash flows is simply t he 100,000 at t ime t = 0. Thus:

In t his example:

Observe t hat as t increases t he present value of each cash flow at t decreases. For example, t he
final incoming cash flow has a fut ure value of 10,000 at t = 12 but has a present value (at t = 0) of
3,186.31. The opposit e of discount ing is compounding. Taking t he example in reverse, it is t he
equivalent of invest ing 3,186.31 at t = 0 (t he present value) at an int erest rat e of 10%
compounded for 12 years, which result s in a cash flow of 10,000 at t = 12 (t he fut ure value).
The import ance of NPV becomes clear in t his inst ance. Alt hough t he incoming cash flows
(10,000 × 12 = 120,000) appear t o exceed t he out going cash flow (100,000), t he fut ure cash
flows are not adjust ed using t he discount rat e. Thus, t he project appears misleadingly profit able.
When t he cash flows are discount ed however, it indicat es t he project would result in a net loss of
31,863.09. Thus, t he NPV calculat ion indicat es t hat t his project should be disregarded because
invest ing in t his project is t he equivalent of a loss of 31,863.09 at t = 0. The concept of t ime
value of money indicat es t hat cash flows in different periods of t ime cannot be accurat ely
compared unless t hey have been adjust ed t o reflect t heir value at t he same period of t ime (in
t his inst ance, t = 0).[2] It is t he present value of each fut ure cash flow t hat must be det ermined in
order t o provide any meaningful comparison bet ween cash flows at different periods of t ime.
There are a few inherent assumpt ions in t his t ype of analysis:

1. The investment horizon of all possible invest ment project s considered are equally
accept able t o t he invest or (e.g. a 3-year project is not necessarily preferable vs. a 20-year
project .)

2. The 10% discount rat e is t he appropriat e (and st able) rat e t o discount t he expect ed cash
flows from each project being considered. Each project is assumed equally speculat ive.

3. The shareholders cannot get above a 10% ret urn on t heir money if t hey were t o direct ly
assume an equivalent level of risk. (If t he invest or could do bet t er elsewhere, no project s
should be undert aken by t he firm, and t he excess capit al should be t urned over t o t he
shareholder t hrough dividends and st ock repurchases.)

More realist ic problems would also need t o consider ot her fact ors, generally including: smaller
t ime bucket s, t he calculat ion of t axes (including t he cash flow t iming), inflat ion, currency
exchange fluct uat ions, hedged or unhedged commodit y cost s, risks of t echnical obsolescence,
pot ent ial fut ure compet it ive fact ors, uneven or unpredict able cash flows, and a more realist ic
salvage value assumpt ion, as well as many ot hers.

A more simple example of t he net present value of incoming cash flow over a set period of t ime,
would be winning a Powerball lot t ery of $500 million. If one does not select t he "CASH" opt ion
t hey will be paid $25,000,000 per year for 20 years, a t ot al of $500,000,000, however, if one does
select t he "CASH" opt ion, t hey will receive a one-t ime lump sum payment of approximat ely
$285 million, t he NPV of $500,000,000 paid over t ime. See "ot her fact ors" above t hat could
affect t he payment amount . Bot h scenarios are before t axes.

Common pitfalls

If, for example, t he Rt are generally negat ive lat e in t he project (e.g. , an indust rial or mining
project might have clean-up and rest orat ion cost s), t hen at t hat st age t he company owes
money, so a high discount rat e is not caut ious but t oo opt imist ic. Some people see t his as a
 problem wit h NPV. A way t o avoid t his problem is t o include explicit provision for financing any
losses aft er t he init ial invest ment , t hat is, explicit ly calculat e t he cost of financing such
losses.

Anot her common pit fall is t o adjust for risk by adding a premium t o t he discount rat e. Whilst a
bank might charge a higher rat e of int erest for a risky project , t hat does not mean t hat t his is a
valid approach t o adjust ing a net present value for risk, alt hough it can be a reasonable
approximat ion in some specific cases. One reason such an approach may not work well can be
seen from t he following: if some risk is incurred result ing in some losses, t hen a discount rat e in
t he NPV will reduce t he effect of such losses below t heir t rue financial cost . A rigorous
approach t o risk requires ident ifying and valuing risks explicit ly, e.g. , by act uarial or Mont e Carlo
t echniques, and explicit ly calculat ing t he cost of financing any losses incurred.

Yet anot her issue can result from t he compounding of t he risk premium. R is a composit e of
t he risk free rat e and t he risk premium. As a result , fut ure cash flows are discount ed by bot h
t he risk-free rat e as well as t he risk premium and t his effect is compounded by each
subsequent cash flow. This compounding result s in a much lower NPV t han might be ot herwise
calculat ed. The cert aint y equivalent model can be used t o account for t he risk premium
wit hout compounding it s effect on present value.

Anot her issue wit h relying on NPV is t hat it does not provide an overall pict ure of t he gain or
loss of execut ing a cert ain project . To see a percent age gain relat ive t o t he invest ment s for
t he project , usually, Int ernal rat e of ret urn or ot her efficiency measures are used as a
complement t o NPV.

Non-specialist users frequent ly make t he error of comput ing NPV based on cash flows aft er
int erest . This is wrong because it double count s t he t ime value of money. Free cash flow
should be used as t he basis for NPV comput at ions.

When using Microsoft 's Excel, t he "=NPV(...)" formula makes t wo assumpt ions t hat result in an
incorrect solut ion. The first is t hat t he amount of t ime bet ween each it em in t he input array is
const ant and equidist ant (e.g., 30 days of t ime bet ween it em 1 and it em 2) which may not
always be correct based on t he cash flow t hat is being discount ed. The second it em is t hat
t he funct ion will assume t he it em in t he first posit ion of t he array is period 1 not period zero.
This t hen result s in incorrect ly discount ing all array it ems by one ext ra period. The easiest fix
t o bot h of t hese errors is t o use t he "=XNPV(...)" formula.

Software support

Many comput er-based spreadsheet programs have built -in formulae for PV and NPV.
History

Net present value as a valuat ion met hodology dat es at least t o t he 19t h cent ury. Karl Marx
refers t o NPV as fict it ious capit al, and t he calculat ion as "capit alising," writ ing:[22]

The forming of a fictitious capital is called capitalising. Every periodically

repeated income is capitalised by calculating it on the average rate of interest, as
an income which would be realised by a capital at this rate of interest.

In mainst ream neo-classical economics, NPV was formalized and popularized by Irving Fisher, in
his 1907 The Rate of Interest and became included in t ext books from t he 1950s onwards, st art ing
in finance t ext s.[23][24]

Alternative capital budgeting methods

Adjust ed present value (APV): adjust ed present value, is t he net present value of a project if
financed solely by ownership equit y plus t he present value of all t he benefit s of financing.

Account ing rat e of ret urn (ARR): a rat io similar t o IRR and MIRR

Cost -benefit analysis: which includes issues ot her t han cash, such as t ime savings.

Int ernal rat e of ret urn (IRR): which calculat es t he rat e of ret urn of a project while disregarding
t he absolut e amount of money t o be gained.

Modified int ernal rat e of ret urn (MIRR): similar t o IRR, but it makes explicit assumpt ions about
t he reinvest ment of t he cash flows. Somet imes it is called Growt h Rat e of Ret urn.

Payback period: which measures t he t ime required for t he cash inflows t o equal t he original
out lay. It measures risk, not ret urn.

Real opt ion: which at t empt s t o value managerial flexibilit y t hat is assumed away in NPV.

Equivalent annual cost (EAC): a capit al budget ing t echnique t hat is useful in comparing t wo or
more project s wit h different lifespans.

Adjusted present value

Adjust ed present value (APV) is a valuat ion met hod int roduced in 1974 by St ewart Myers.[25] The
idea is t o value t he project as if it were all equit y financed ("unleveraged"), and t o t hen add t he
present value of t he t ax shield of debt – and ot her side effect s.[26]

Accounting rate of return

The account ing rat e of ret urn, also known as average rat e of ret urn, or ARR, is a financial rat io
used in capit al budget ing.[27] The rat io does not t ake int o account t he concept of t ime value of
money. ARR calculat es t he ret urn, generat ed from net income of t he proposed capit al
invest ment . The ARR is a percent age ret urn. Say, if ARR = 7%, t hen it means t hat t he project is
expect ed t o earn seven cent s out of each dollar invest ed (yearly). If t he ARR is equal t o or
great er t han t he required rat e of ret urn, t he project is accept able. If it is less t han t he desired
rat e, it should be reject ed. When comparing invest ment s, t he higher t he ARR, t he more at t ract ive
t he invest ment . More t han half of large firms calculat e ARR when appraising project s.[28]

Cost-benefit analysis

Cost –benefit analysis (CBA), somet imes also called benefit –cost analysis, is a syst emat ic
approach t o est imat ing t he st rengt hs and weaknesses of alt ernat ives. It is used t o det ermine
opt ions which provide t he best approach t o achieving benefit s while preserving savings in, for
example, t ransact ions, act ivit ies, and funct ional business requirement s.[29] A CBA may be used t o
compare complet ed or pot ent ial courses of act ion, and t o est imat e or evaluat e t he value against
t he cost of a decision, project , or policy. It is commonly used t o evaluat e business or policy
decisions (part icularly public policy), commercial t ransact ions, and project invest ment s. For
example, t he U.S. Securit ies and Exchange Commission must conduct cost -benefit analyses
before inst it ut ing regulat ions or deregulat ions.[30]: 6

1. To det ermine if an invest ment (or decision) is sound, ascert aining if – and by how much – it s
benefit s out weigh it s cost s.

2. To provide a basis for comparing invest ment s (or decisions), comparing t he t ot al expect ed
cost of each opt ion wit h it s t ot al expect ed benefit s.

Internal rate of return

Int ernal rat e of ret urn (IRR) is a met hod of calculat ing an invest ment 's rat e of ret urn. The t erm
internal refers t o t he fact t hat t he calculat ion excludes ext ernal fact ors, such as t he risk-free
rat e, inflat ion, t he cost of capit al, or financial risk.

Modified internal rate of return

The modified int ernal rat e of ret urn (MIRR) is a financial measure of an invest ment 's
at t ract iveness.[31][32] It is used in capit al budget ing t o rank alt ernat ive invest ment s of unequal
size. As t he name implies, MIRR is a modificat ion of t he int ernal rat e of ret urn (IRR) and as such
aims t o resolve some problems wit h t he IRR.

Payback period

Payback period in capit al budget ing refers t o t he t ime required t o recoup t he funds expended in
an invest ment , or t o reach t he break-even point . [33]
Equivalent annual cost

In finance, t he equivalent annual cost (EAC) is t he cost per year of owning and operat ing an asset
over it s ent ire lifespan. It is calculat ed by dividing t he negat ive NPV of a project by t he "present
value of annuit y fact or":

, where

where r is t he annual int erest rat e and

t is t he number of years.

Alt ernat ively, EAC can be obt ained by mult iplying t he NPV of t he project by t he "loan repayment
fact or".

EAC is oft en used as a decision-making t ool in capit al budget ing when comparing invest ment
project s of unequal lifespans. However, t he project s being compared must have equal risk:
ot herwise, EAC must not be used.[34]

The t echnique was first discussed in 1923 in engineering lit erat ure,[35] and, as a consequence, EAC
appears t o be a favoured t echnique employed by engineers, while account ant s t end t o prefer net
present value (NPV) analysis.[36] Such preference has been described as being a mat t er of
professional educat ion, as opposed t o an assessment of t he act ual merit s of eit her met hod.[37]
In t he lat t er group, however, t he Societ y of Management Account ant s of Canada endorses EAC,
having discussed it as early as 1959 in a published monograph[38] (which was a year before t he
first ment ion of NPV in account ing t ext books).[39]

See also

Profit abilit y index

References

1. Lin, Grier C. I.; Nagalingam, Sev V. (2000). CIM justification and optimisation. London: Taylor &
Francis. p. 36. ISBN 0-7484-0858-4.

2. Berk, DeMarzo, and St angeland, p. 94.

3. erk, DeMarzo, and St angeland, p. 64.

4. Khan, M.Y. (1993). Theory & Problems in Financial Management. Bost on: McGraw Hill Higher
Educat ion. ISBN 978-0-07-463683-1.
 5. Javed, Rashid (2016-12-28). "Net present value (NPV) met hod - explanat ion, example,
assumpt ions, advant ages, disadvant ages" (ht t ps://www.account ingformanagement .org/net -
present -value-met hod/) . Accounting For Management. Ret rieved 2023-04-21.

6. Davies, Wayne (2012-10-01). "Proposed Modificat ions t o t he Cost -Benefit Analysis Decision
Crit eria for Road Project Evaluat ion t o Improve Decisionmaking" (ht t ps://scholarlypublishing
collect ive.org/psup/t ransport at ion-journal/art icle/51/4/473/289797/Proposed-Modificat io
ns-t o-t he-Cost -Benefit ) . Transportation Journal. 51 (4): 473–487.
doi:10.5325/t ransport at ionj.51.4.0473 (ht t ps://doi.org/10.5325%2Ft ransport at ionj.51.4.047
3) . ISSN 0041-1612 (ht t ps://search.worldcat .org/issn/0041-1612) . S2CID 154096977 (h
t t ps://api.semant icscholar.org/CorpusID:154096977) .

7. "Mid Period Definit ion, Calculat ion, Applicat ions" (ht t ps://www.fe.t raining/free-resources/val
uat ion/mid-period/) . Financial Edge. Ret rieved 2023-04-21.

8. "NPV Met hod - NPV and Risk Modelling for Project s" (ht t p://www.project npv.com/3.ht ml) .
www.projectnpv.com. Ret rieved 2023-04-21.

9. Baker, Samuel L. (2000). "Perils of t he Int ernal Rat e of Ret urn" (ht t p://sambaker.com/econ/i
nvest /invest .ht ml) . Ret rieved January 12, 2007.

10. Serfas, Sebast ian (2011). Cognitive Biases in the Capital Investment Context. Germany:
Cabler Verlag. pp. 30–255. ISBN 9783834926432.

11. "Net Present Value (NPV): What It Means and St eps t o Calculat e It " (ht t ps://www.invest op
edia.com/t erms/n/npv.asp) . Investopedia . Ret rieved 2023-04-21.

12. "Some Alt ernat ive Invest ment Rules" (ht t ps://webpage.pace.edu/pviswanat h/not es/corpfi
n/invrules.ht ml) . webpage.pace.edu. Ret rieved 2023-04-21.

13. Ngwira, Malawi; Manase, David (2016). Public Sector Property Asset Management. UK: Wiley-
Blackwell. pp. 115–193. ISBN 978-1-118-34658-7.

14. "Sensit ivit y Analysis Definit ion" (ht t ps://www.invest opedia.com/t erms/s/sensit ivit yanalysis.a
sp) . Investopedia . Ret rieved 2023-04-21.

15. "Disadvant ages of Net Present Value (NPV) for Invest ment s" (ht t ps://www.invest opedia.co
m/ask/answers/06/npvdisadvant ages.asp) . Investopedia . Ret rieved 2022-04-30.

16. Damodaran, Aswat h (21 April 2023). "Cash Flow and Discount Rat es" (ht t ps://pages.st ern.ny
u.edu/~adamodar/podcast s/valUGspr21/session4slides.pdf) (PDF). New York University.
Ret rieved 21 April 2023.
17. Fiorit i, Davide; Pint us, Salvat ore; Lut zemberger, Giovanni; Poli, D. (2020-06-01). "Economic
mult i-object ive approach t o design off-grid microgrids: A support for business decision
making (comparison of different economic crit eria)" (ht t ps://www.researchgat e.net /publicat
ion/342147652) . Renewable Energy. doi:10.1016/j.renene.2020.05.154 (ht t ps://doi.org/10.1
016%2Fj.renene.2020.05.154) . S2CID 224855745 (ht t ps://api.semant icscholar.org/CorpusI
D:224855745) .

18. Mendell, Brooks (2020-05-31). "Pros and Cons of Using Net Present Value (NPV)" (ht t ps://fo
risk.com/blog/2020/05/31/pros-and-cons-of-using-net -present -value-npv/) . Forisk.
Ret rieved 2023-04-21.

19. de Rus, Ginés (2021). Introduction to Cost-Benefit Analysis: Looking for Reasonable
Shortcuts. Second edition, 2021. UK: Edward Elgar. pp. 136–245. ISBN 978-1-83910-374-2.

20. Buser, St ephen A. (March 1986). "LaPlace Transforms as Present Value Rules: A Not e". The
Journal of Finance. 41 (1): 243–247. doi:10.1111/j.1540-6261.1986.t b04502.x (ht t ps://doi.or
g/10.1111%2Fj.1540-6261.1986.t b04502.x) .

21. Grubbst röm, Robert W. (March 1967). "On The Applicat ion of t he Laplace Transform t o
Cert ain Economic Problems". Management Science. 13 (7): 558–567.
doi:10.1287/mnsc.13.7.558 (ht t ps://doi.org/10.1287%2Fmnsc.13.7.558) . JSTOR 2627695
(ht t ps://www.jst or.org/st able/2627695) .

22. Karl Marx, Capital, Volume 3, 1909 edit ion, p. 548

23. Bichler, Shimshon; Nit zan, Jonat han (July 2010), Systemic Fear, Modern Finance and the
Future of Capitalism (ht t p://bnarchives.yorku.ca/289/03/20100700_ bn_ syst emic_ fear_ mo
dern_ finance_ fut ure_ of_ capit alism.pdf) (PDF), Jerusalem and Mont real: bnarchives.net ,
pp. 8–11 (for discussion of hist ory of use of NPV as "capit alisat ion")

24. Nit zan, Jonat han; Bichler, Shimshon (2009), Capital as Power. A Study of Order and Creorder. ,
RIPE Series in Global Polit ical Economy, New York and London: Rout ledge

25. Myers, S.C. (1974), “Int eract ions of Corporat e Financing and Invest ment Decisions –
Implicat ions for Capit al Budget ing”, Journal of Finance (March), pp. 1–25 (ht t p://cit eseerx.is
t .psu.edu/viewdoc/download?doi=10.1.1.468.1912&rep=rep1&t ype=pdf)

26. Dirk Jent er (2003). WACC and APV (ht t ps://ocw.mit .edu/courses/sloan-school-of-managem
ent /15-402-finance-t heory-ii-spring-2003/lect ure-not es/lec14awaccapv.pdf) , MIT OCW
course-not es

27. Account ing Rat e of Ret urn - ARR (ht t p://www.answers.com/t opic/account ing-rat e-of-ret ur
n-arr)

28. Arnold, G. (2007). Essent ials of corporat e financial management . London: Pearson Educat ion,
Lt d.
29. David, Rodreck; Ngulube, Pat rick; Dube, Adock (16 July 2013). "A cost –benefit analysis of
document management st rat egies used at a financial inst it ut ion in Zimbabwe: A case st udy"
(ht t ps://doi.org/10.4102%2Fsajim.v15i2.540) . SA Journal of Information Management. 15
(2). doi:10.4102/sajim.v15i2.540 (ht t ps://doi.org/10.4102%2Fsajim.v15i2.540) .

30. Hirst , Scot t (2018-07-01). "The Case for Invest or Ordering" (ht t ps://scholarship.law.bu.edu/f
acult y_ scholarship/343) . The Harvard Law School Program on Corporate Governance
Discussion Paper (2017–13).

31. Lin, St even A. Y. (January 1976). "The Modified Int ernal Rat e of Ret urn and Invest ment
Crit erion". The Engineering Economist. 21 (4): 237–247. doi:10.1080/00137917608902796 (h
t t ps://doi.org/10.1080%2F00137917608902796) .

32. Beaves, Robert G. (January 1988). "Net Present Value and Rat e of Ret urn: Implicit and
Explicit Reinvest ment Assumpt ions". The Engineering Economist. 33 (4): 275–302.
doi:10.1080/00137918808966958 (ht t ps://doi.org/10.1080%2F00137918808966958) .

33. Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibst ein (2010). Marketing Metrics:
The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey:
Pearson Educat ion, Inc. ISBN 0-13-705829-2. The Market ing Account abilit y St andards
Board (MASB) endorses t he definit ions, purposes, and const ruct s of classes of measures
t hat appear in Marketing Metrics as part of it s ongoing Common Language: Market ing
Act ivit ies and Met rics Project (ht t p://www.t hemasb.org/common-language/) .

34. Copeland & West on 1988, p. 51.

35. Fish, John Charles Lounsbury (1923). Engineering Economics (ht t ps://archive.org/det ails/eng
ineeringecono00fishuoft ) (2nd ed.). New York: McGraw-Hill. ASIN B001CZKN9K (ht t ps://w
ww.amazon.com/dp/B001CZKN9K) ., and expanded upon in Grant , Eugene L. (1930).
Principles of Engineering Economy. New York: Ronald Press.

36. Jones & Smit h 1982, p. 103.

37. Jones & Smit h 1982, p. 108.

38. Edge, C. Geoffrey (1959). The appraisal of capital expenditures (ht t p://collect ionscanada.gc.
ca/ourl/res.php?url_ ver=Z39.88-2004&url_ t im=2015-11-09T14%3A20%3A58Z&url_ ct x_ fmt
=info%3Aofi%2Ffmt %3Akev%3Amt x%3Act x&rft _ dat =11838055&rfr_ id=info%3Asid%2Fcoll
ect ionscanada.gc.ca%3Aamicus&lang=eng) . Hamilt on: Societ y of Indust rial Account ant s
of Canada. OL 16634923M (ht t ps://openlibrary.org/books/OL16634923M) .

39. Jones & Smit h 1982, p. 106.