Net Present Value

Read this section that discusses Net Present Values (NPV), calculating and interpreting NP, and the advantages and disadvantages of using NPV. It also gives examples of how these concepts are implemented in practical applications.

Advantages of the NPV Method

NPV is easy to use, easily comparable, and customizable.

LEARNING OBJECTIVE

Describe the advantages of using net present value to evaluate potential investments

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.

Calculating the NPV is a way 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 is 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 straight forward.

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 rather gain nor lose value for the firm	We should be indifferent in the decision whether to accept or reject the project. This project adds to monetary value. Decision 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 or not. It's easy of use in decision making is one of its advantages.

Another advantage of the NPV method is that it allows for easy comparisons of potential investments. As long as the NPV of all options are taken at the same point in time, the investor can compare the magnitude of each option. When presented with the NPVs of multiple options, the investor will simply 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 financial concerns and demands of the firm. For example, the discount rate can be adjusted to reflect things such as risk, opportunity cost, and changing yield curve premiums on long-termdebt.