Net present value
(NPV).
1.
The total present value of all of the cash flows of a proposal - both positive and negative - netting off negative present values against positive ones.
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 very 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 the basis of this simple form of the NPV decision rule) 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:
- All negative NPV opportunities should still be rejected; while
- All positive NPV opportunities remain eligible for further consideration (rather than automatically being accepted).
