Net Present Value
Advantages of the NPV method
NPV is easy to use, easily comparable, and customizable.
Calculating the NPV is how investors determine how attractive a potential investment is. Since it essentially determines the present value of the gain or loss of an investment, it is easy to understand and a great decision-making tool.
When
NPV is positive, the investment is worthwhile. On the other hand, when it is negative, it should not be undertaken, and when it is 0, there is no difference in the present values of the cash outflows and inflows. In theory, an investor should undertake positive NPV investments and never undertake negative NPV investments. Thus, NPV makes the decision-making process relatively straightforward.
| If... | It means... | Then... |
|---|---|---|
| NPV > 0 | The investment would add value to the firm | The project may be accepted |
| NPV < 0 | The investment would subtract value from the firm | The project should be rejected |
| NPV = 0 | The investment would neither gain nor lose value for the firm | We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decisions should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation. |
NPV Decision Table NPV simply and clearly shows whether a project adds value to the firm. One of its advantages is its ease of use in decision-making.
Another advantage of the NPV method is that it allows for
easy comparisons of potential investments. As long as the NPV of all
options is taken at the same point, the investor can compare
the magnitude of each option.
When presented with the NPVs of multiple options, the investor will choose the option with the highest NPV because it will provide the most additional value for the firm. However, if none of the options has a positive NPV, the investor will not choose any of them; none of the investments will add value to the firm, so the firm is better off not investing.
Furthermore, NPV is customizable so that it accurately reflects the firm's financial concerns and demands. For example, the discount rate can be adjusted to reflect risk, opportunity cost, and changing yield curve premiums on long-term debt.
Key Points
- When NPV is positive, it adds value to the firm. When it is negative, it subtracts value. An investor should never undertake a negative NPV project.
- As long as all options are discounted to the same point in time, NPV allows for easy comparison between investment options. The investor should undertake the investment with the highest NPV, provided it is possible.
- An advantage of NPV is that the discount rate can be customized to reflect a number of factors, such as risk in the market.
Term
- Gain (or Loss) – if an investment earns more value than it costs, the difference is the gain. If it costs more than it earns, the difference is a loss.