Capital Budgeting

Session 8
 Net Present Value
NPV is the sum of the present values of all the expected
incremental cash flows of a project discounted at a
required rate of return less the present value of the cost
of the investment.
Net Present value

• In other words, NPV is the difference between the present value of cash
inflows of a project and the initial cost of the project. As per this technique, the
projects whose NPV is positive or above zero shall be selected.

• If a project’s NPV is less than zero or negative, the same must be rejected.
Further, if there is more than one project with positive NPV, then the project
with the highest NPV shall be selected.
NPV Formula
• If there’s one cash flow from a project that will be paid one year
from now, then the calculation for the NPV is as follows:
Example
• Imagine a project that costs $1,000 and will provide three cash
flows of $500, $300, and $800 over the next three years. Assume
that there is no salvage value at the end of the project and that the
required rate of return is 8%. The NPV of the project is calculated
as follows:
Try this one!

• A Company is considering the purchase of a copier at Rs. 5000. Assume a cost of

capital of 10% and the following cash flow schedule to determine whether the copier
must be purchased.

Year 1 2 3
Cash flow 3,000 2,000 2,000

The present value of cash flows @ 10% are

Rs. 2,727, Rs. 1,653 and Rs. 1,503. The sum is Rs. 5,883.
NPV = Present value of Cumulative Cash Inflow - Cash outflow
NPV = 5,883 - Rs. 5,000 = Rs. 883.

Since NPV is positive, the copier may be purchased.