NPV Decision Rules  – Capital Budgeting Techniques

Net Present Value is defined as the present value of all expected cash flows generated by the project minus present value of the cost of the project.

Net Present Value = Present value of all expected cash inflows – Present value of the cost of the project

We use hurdle rate as discount rate while calculating NPV of the project.

NPV of the project can be positive, zero or negative. Depending on the value of the net present value, we accept or reject the project.

If NPV is positive, benefits of the project are enough to cover

• The cost of asset
• Project’s financing cost
• and the rate of return that sufficiently payoff the company for the risk found in estimating cash flows.

If NPV is positive (NPV > 0) then

Present value of expected cash flows > Present value of cost of the project

We expect to earn more than minimum required rate of return.

Therefore, we will accept the investment.

If NPV is Zero (NPV=0) then

We are at break-even (i.e. no profit no loss), benefits of the project are hardly enough to cover these costs.

Present value of expected cash flows = Present value of cost of the project

We expect to earn exactly equal to the minimum required rate of return.

Therefore, we would be indifferent about accepting the investment.

If NPV is Negative (NPV<0) then

Benefits of the project are not enough to cover these costs.

Present value of expected cash flows < Present value of cost of the project

We expect to earn less than minimum required rate of return.

Therefore, we should reject the project if NPV is negative.