Net Present Value
A project's net present value is determined by
summing the net annual cash flow, discounted at the project's cost of capital
and deducting the initial outlay. Decision criteria is to accept a project with
a positive net present value. Advantages of this method are that it reflects
the time value of money and maximizes shareholder's wealth. Its weakness is
that its rankings depend on the cost of capital; present value will decline as
the discount rate increases.
A company chooses the expected
number of years required to recover an original investment. Projects will only
be selected if initial outlay can be recovered within a predetermined period.
This method is relatively easy since the cash flow doesn't need to be
discounted. Its major weakness is that it ignores the cash inflows after the
payback period, and does not consider the timing of cash flows.
This is the ratio of the present
value of project cash inflow to the present value of initial cost. Projects with
a Profitability Index of greater than 1.0 are acceptable. The major
disadvantage in this method is that it requires cost of capital to calculate
and it cannot be used when there are unequal cash flows. The advantage of this
method is that it considers all cash flows of the project.
Net Present Value
The sum of discounted costs are
subtracted from the sum of discounted benefits. Projects with positive net
present value should be considered; the greater the net present value, the more
justifiable the project. However, a large project could have a higher net
present value than a smaller project, even if it has a lower benefit-cost
In finance, the net present value
(NPV) or net present worth (NPW) of a time series of cash flows, both incoming
and outgoing, is defined as the sum of the present values (PVs) of the
individual cash flows of the same entity.
In the case when all future cash
flows are incoming (such as coupons and principal of a bond) and the only
outflow of cash is the purchase price, the NPV is simply the PV of future cash
flows minus the purchase price (which is its own PV). NPV is a central tool in
discounted cash flow (DCF) analysis and is a standard method for using the time
value of money to appraise long-term projects. Used for capital budgeting and
widely used throughout economics, finance, and accounting, it measures the
excess or shortfall of cash flows, in present value terms, above the cost of
NPV can be described as the 'difference
the sums of discounted: cash inflows and cash outflows. It compares the present
value of money today to the present value of money in the future, taking
inflation and returns into account.
The NPV of a sequence of cash flows takes as input
the cash flows and a discount rate or discount curve and outputs a price; the
converse process in DCF analysis - taking a
sequence of cash flows and a price as input and inferring as output a discount
rate (the discount rate which would yield the given price as NPV) - is
called the yield and is more widely used in bond trading.