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.
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 all positive NPV opportunities should be accepted, and all negative NPV opportunities should be rejected. So the project in the example above would be accepted 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).
See also
- Capital rationing
- Discounted cash flow
- Internal rate of return
- Investment appraisal
- Present value
- Residual theory
