Net present value

(NPV).

1.

The total present value of all of the cash flows of a proposal - both positive and negative.

For example, the expected future cash inflows from an investment project LESS the initial capital investment outflow at Time 0.

Example

For example, a project requires an investment today of $100m, with $120m being receivable one year from now.

The cost of capital (r) is 10% per annum.

The NPV of the project is calculated as follows:

PV of Time 0 outflow $100m

= $(100m)

PV of Time 1 inflow $120m = $120m x 1.1^-1

= $109.09m

NPV = -$100m +$109.09m

= +$9.09m

2.

In simple Net Present Value analysis the decision rule would be that:

(1) All positive NPV opportunities should be accepted.

(2) All negative NPV opportunities should be rejected.

So the project in the example above would be accepted - on this basis - because its NPV is positive, namely +$9.09m.

However this assumes the unlimited availability of further capital with no increase in the cost of capital.

A more refined decision rule is that:

(1) All negative NPV opportunities should still be rejected; while

(2) All positive NPV opportunities remain eligible for further consideration (rather than automatically being accepted).

See also

• Capital rationing
• Discounted cash flow
• Internal rate of return
• Investment appraisal
• Present value
• Residual theory