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# Net Present Value

The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to increase the value of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected.

The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula:

where

• CFt = the cash flow at time t and
• r = the cost of capital.

The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for the project is 10%.

 Project A Project B Year Cash Flow Cash Flow 0 \$-1000 \$-1000 1 500 100 2 400 200 3 200 200 4 200 400 5 100 700

 Net Present Value Project A: Project B:

Thus, if Projects A and B are independent projects then both projects should be accepted. On the other hand, if they are mutually exclusive projects then Project A should be chosen since it has the larger NPV.

 Example Problems Find the NPV for the following Capital Budgeting project. Year Cash Flow 0 \$ 1 \$ 2 \$ 3 \$ 4 \$ 5 \$ Cost of Capital: % NPV: \$

© 2002 - 2010 by Mark A. Lane, Ph.D.