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
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).
