Net Present value ( NPV )

The method used by large companies to evaluate investment  project is called net present values ( NPV ). the intuition behind the NPV method is simple.When firms make investments, they are spending money that they obtained in one form or another. from investor. Investor Expect a return of money that they give to firms, so a firm should undertake an investment only if the present value of the cash flow that the investment generates is greater than the cost of making investment in the first place. Because the NPV method takes into  account the time value of investor's money, it is more sophisticated capital budgeting technique than payback period rule. The NPV method discounts the firm's cash flows at the firm's cost of capital.This rate is the minimum return that must be earned on a project to satisfy the firm's investors. Project with lower return fail meet investor's expectations and therefore decrease firm value, and projects with higher returns increase firm value.

The net present value ( NPV ) is found by subtracting a project's initial investment ( CF-0 ) from present value of its cash inflows ( CF-t) discounted at a rate equal to the firms cost of capital ( r ).

when NPV is used, both inflows and outflows are measure in terms of present dollars. For a project that cash outflows beyond the initial investment, the net present value of a project would be found by subtracting the present value of outflows from the present value of inflows.

Decision Criteria 

When NPV is used to make accept - reject decision, the decisions criteria are as follows :

• If the NPV is greater than $0 than, accept the project.
• If the NPV is less than $0 than, reject the project.

if the NPV is greater than $0, the firm will earn a return greater than its cost of capital. such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to NPV.

Example 

We can illustrate the net present value ( NPV ) approach by using the Bennet Company data presented below. If the firm has a 10% cost of capital, the net present values for project A ( an annuity ) and B ( a mixed stream) can be calculated below :

Time Line For project A

Time Line for Project B

These calculation result in net present values for project A and B of $11,071 and $10,924, respectively. Both projects are acceptable, because the net present value of each is greater than $0. If the project were being ranked, however , project a would be considered superior to B, because it has higher net present value tan that of B ( $11,071 versus $10,924).