net present value of an investment
What is the net present value of an investment, and
how do you calculate it?
The net present value of
a project measures the difference between its value and cost. NPV is therefore
the amount that the project will add to
shareholder wealth. A company maximizes shareholder wealth by accepting
all projects that have a positive NPV.
How is the internal rate of return of a project
calculated and what must one look out for when using the internal rate of
return rule?
Instead of asking whether a project has a positive
NPV, many businesses prefer to ask whether it offers a higher return than
shareholders could expect to get by
investing in the capital market. Return is usually defined as the discount rate
that would result in a zero NPV. This is known as the internal rate
of return, or IRR. The
project is attractive if the IRR exceeds the opportunity cost of capital.
There are some pitfalls in using the internal rate of
return rule. Be careful about using the IRR when (1) the early cash flows are
positive, (2) there is more than one
change in the sign of the cash flows, or (3) you need to choose between two mutually exclusive projects.
Why don t the payback rule and book rate of return
rule always make shareholders better off?
The net present value rule and the rate of return rule
both properly reflect the time value o money. But companies sometimes use rules
of thumb to judge projects. One is the payback rule, which states that a project is acceptable if you get
your money back within a specified period. The
payback rule takes no account of any cash flows that arrive after the
payback period and fails to discount cash flows within the payback period.
Book (or accounting) rate of return is the income of a project divided by the book value.
Unlike the internal rate of return, book rate of return does not depend just on the project s cash
flows. It also depends on which cash flows are classified as capital
investments and which as operating
expenses. Managers often keep an eye on how projects would affect book
return.
How can the net present value rule be used to analyze
three common problems that involve competing projects: when to postpone an investment expenditure; how to choose
between projects with equal lives; and when to replace equipment?
Sometimes a project may have a positive NPV if
undertaken today but an even higher NPV if the investment is delayed. Choose
between these alternatives by comparing
their NPVs today.
When you have to choose between projects with
different lives, you should put them on an equal footing by comparing the equivalent annual
cost or benefit of the
two projects. When you are considering whether to replace an aging machine with
a new one, you should compare the cost of operating the old one with the
equivalent annual cost of the new one.
How is the profitability index calculated, and how can
it be used to choose between projects when funds are limited?
If there is a shortage of capital, companies need to
choose projects that offer the highest net present value per dollar of
investment. This measure is known as the profitability index.
10 Unfortunately,
when capital is rationed in more than one period, or when personnel, production
capacity, or other resources are rationed in
addition to capital, it isn t always possible to get the NPV-maximizing
package just by ranking projects on their profitability index. Tedious
trial and error may be called for, or
linear programming methods may be used.
Category: Cash flows
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