Net Present Value Rule

Refers to the rule that investors and business management should only fund initiatives or enter into deals with a positive net present value (NPV)

Author: Michael Rahme
Michael Rahme
Michael Rahme
Reviewed By: Aditya Salunke
Aditya Salunke
Aditya Salunke
Last Updated:March 1, 2024

What is the Net Present Value Rule?

According to the net present value rule, investors and business management should only fund initiatives or enter into deals with a positive net present value (NPV).

Investments in initiatives with a negative net present value ought to be avoided. It follows from the principle of net present value.

The net present value is the difference between an investment's market value and cost. In other words, it is the current value of the projected cash flows of an investment project, discounted back at an appropriate rate. 

The basic idea is to create value by identifying an investment worth more in the marketplace than it initially cost us to acquire. 

The net present value is integral to the capital budgeting process of any organization. It involves considering all cash flows, expenses, and profits related to a product or investment to determine its profitability.

When NPV is positive, we know that the project is worth investing in, while when it is negative, we assume the opposite.

Key Takeaways

  • The Net Present Value (NPV) rule dictates that only projects with a positive NPV should be pursued, while those with a negative NPV should be avoided, aligning to maximize shareholder wealth.
  • NPV is determined by subtracting the initial investment cost from the present value of expected cash flows, discounted at a specified rate, providing a quantitative measure of project profitability.
  • A positive NPV indicates that an investment is expected to generate returns exceeding the cost of capital, warranting acceptance, whereas a negative NPV suggests the investment would erode shareholder value and should be rejected.
  • NPV analysis considers all cash flows associated with a project, factoring in their timing and magnitude, offering a comprehensive assessment of investment viability.

Net Present Value Calculation

As the goal of financial management is to increase shareholder value, this brings us to the net present value rule. When the net present value of an investment is positive, it should be accepted; if it is negative, it should be rejected. Let's look at an example using the proper steps.

A project in which you initially invested $72,500 provides consecutive annual cash flows of $14,700 for six years. Is this a good project if the discount rate is 7 percent?

We'll calculate by using the formula:

NPV = ΣRt/ (1 + i)^t

Present value = $14,700/ (1 + 0.07)^1 = $13,738.32

Present value = $14,700/ (1 + 0.07)^2 = $12,839.55

Present value = $14,700/ (1 + 0.07)^3 = $11,999.58

Present value = $14,700/ (1 + 0.07)^4 = $11,214.56

Present value = $14,700/ (1 + 0.07)^5 = $10,480.90

Present value = $14,700/ (1 + 0.07)^6 = $9,795.23

Total Present Value = $13,738.32 + $12,839.55 + $11,999.58 + $11,214.56 + $10,480.90 + $9,795.23 = $70,068.14

So,

NPV = $70,068.14 - $72,500 = (- $2,431.86)

We would reject this project with a required rate of 7%. 

Example 2

Suppose you are asked to decide whether a new product should be launched. We expect the cash flows over the next four years to be $2,000 in the first two, then $4,000 for the third year, and $5,000 for the fourth.

It will cost you $9,000 to start production. Use a 10% discount rate to evaluate the products. We'll calculate it by:

Present value = [$2,000/1.1] + [$2,000/(1.1^2)] + [$4,000/(1.1^3)] + [$5,000/(1.1^4)]

= $1,818 + $1,653 + $3,005 + $3,415 = $9,891

NPV = $9,891 - $9,000 = $891

The net present value is positive, so you should take on this project. 

How does Net Present Value Work?

Based on our previous example, you can see how we would make our capital budgeting decision. The first step is to look at what other fixed-up properties were selling for in the market. 

Then, we would get estimates of the cost of buying a particular property and compare it to the market prices. So far, we have the estimated total cost and estimated market value.

If the difference is positive, we would consider investing in the project as it would have a positive estimated net present value. In our example, we have information on the market prices for other properties, which considerably simplifies the process. 

Most of the time, however, investors are left with indirect market information, making it more challenging to estimate their investments.

The NPV analysis assesses the value of an investment or project by considering its cash flows. It is an all-encompassing metric because it includes all revenues, expenses, and capital costs associated with an investment in its free cash flow (FCF).

It accounts for the timing of cash flows, which can affect the present value of an investment—for example, receiving cash inflows sooner and having cash outflows later rather than the reverse is better.

For more practice, please view the video below. 

Excel NPV Functions

Excel has two net present value functions: NPV and XNPV. Both functions utilize the same mathematical formula but save analysts time by automating the calculation process.

The standard NPV function =NPV() assumes that all cash flows occur at regular intervals (e.g., annually, quarterly, monthly) and disregards any fluctuations in those intervals.

The XNPV function =XNPV() enables users to assign specific dates to individual cash flows, accommodating irregular intervals. This feature is advantageous for dealing with unevenly spaced cash flows, ensuring a more precise calculation.

Internal Rate of Return (IRR) vs. NPV

The internal rate of return, better known as the IRR, refers to the interest rate at which the investment's net present value equals zero. Another way to put it is the annual compound rate of return you can expect from a project or investment.

Consider, for example, a company considering the purchase of a new piece of equipment priced at $25,000. This investment entails an initial cash outflow of $25,000, with the equipment generating annual cash inflows of $6,000 for eight years.

The $6,000 inflow would be discounted using the discount rate of 7% for eight years. The investment is only profitable if the sum of all adjusted cash inflows and outflows is more significant than zero.

A positive NPV indicates a greater rate of return than the 7% discount rate. To calculate, we'll use:

Present Value Sum = $35,827.79 - $25,000

 NPV = 10,827.79

Based on our example, we know that since there is a positive net cash inflow, our rate of return is higher than the discount rate.

    Note

    While the IRR can be informative, it is often considered inferior to NPV due to its reliance on capital allocation and reinvestment assumptions. In most cases, investors and business management consider NPV and IRR when considering projects.

    Challenges of net present value

    Although net present value (NPV) is the most commonly used method to evaluate investment opportunities, it does have some drawbacks that should be carefully examined.

    In NPV analysis, key challenges include:

    • The need for numerous assumptions introduces uncertainty
    • Susceptibility to minor alterations in assumptions and variables
    • Potential for manipulation to achieve desired outcomes
    • Second- and third-order benefits/impacts may not be captured (i.e., on other parts of the business)
    • Assumption of a constant discount rate
    • Difficulty in precisely adjusting for risk due to challenges in acquiring data on correlations and probabilities

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