What is the Net Present Value Rule?
The net present value rule is an investment concept stating that projects should only be engaged in if they demonstrate a positive net present value (NPV). Additionally, any project or investment with a negative net present value should not be undertaken.
Understanding Net Present Value (NPV)
Net Present Value (NPV) is the calculated difference between net cash inflows and net cash outflows over a time period. NPV is commonly used to evaluate projects in capital budgeting and also to analyze and compare different investments.
Net Present Value = Present Value of Cash Inflows – Present Value of Cash Outflows
A positive NPV indicates that a project or investment is profitable when discounting the cash flows by a certain discount rate, whereas, a negative NPV indicates that a project or investment is unprofitable.
A discount rate, also known as a required rate of return, is an interest rate that is used to determine the present value of a series of cash flows. For internal projects, the rate can be referred to as the cost of capital, which is the required return that is needed to make a project worthwhile.
Positive NPV projects essentially show that the present value of cash flows generated from a project or investment exceeds the costs required for the project. Therefore, a positive NPV project or investment is said to “create value.” A negative NPV project or investment shows that the costs exceed the cash flows generated, and it is said to “destroy value.”
Net Present Value Calculation
The time value of money is based on the idea in finance that money in the present is worth more than money in the future.
For example, if you are offered either $100 today or $100 one year from now. A rational person would rather have the $100 today. Intuitively, if you had the $100 today, you could invest the money for one year and have more than $100. Additionally, assuming there is inflation, $100 in one year would not even have the same purchasing power as today, so accepting the $100 could leave you worse off.
Now, what if you were offered either $100 today, or $105 one year from now. Now the answer is not as clear, and depends on market conditions, primarily, the interest rate that you would receive on investing $100 for one year.
If the interest rate for a one-year investment was greater than 5%, then you would prefer the $100 today so you could invest it. If the interest rate was less than 5%, then you would rather take $105 since it would be worth more than $100 invested. Lastly, if the interest rate was exactly 5%, then you would be indifferent between the options.
Obviously, the above is a simplified example that does not include any risk or other factors; however, it illustrates the underlying concept behind the NPV rule.
As mentioned earlier, the interest rate is also referred to as a discount rate, and for projects, it would represent the expected return on other projects with similar risk.
A company is given the option to invest in a project that costs $1,200 initially to undertake. The project generates $500 every year for six years. However, it requires a second outlay of $1,200 in the third year. At a cost of capital of 10%, should the project be undertaken?
|Cost of Capital||10%||Net Present Value||$69|
It can be calculated with a financial calculator or in a spreadsheet. The following general steps should be taken:
1. Lay out the cash outflows and inflows for each time period.
2. Net the cash outflows and inflows by adding them.
3. Calculate the present value of each cash flow by discounting at the specified cost of capital.
4. Add the present value of all cash flows to arrive at the net present value.
In the example above, the NPV is +$69. Since it is positive, based on the NPV rule, the project should be undertaken.
Importance of the Net Present Value Rule
The NPV rule seems like a simple concept. However, the management of companies sometimes does not even utilize it to determine whether or not they are creating or destroying shareholder value. If a company consistently undertakes negative NPV projects, they are destroying equity value since the capital used to fund the projects is more costly than the return they are earning.
Generally, if a company cannot find a positive NPV project, it should return the capital to shareholders via a dividend or a share repurchase. A company that ignores the NPV rule will be a poor long-term investment due to poor corporate governance.
It emphasizes that a company should not be or investing just for the sake of investing. The company’s management should be wary of its cost of capital, as well as their capital allocation decisions. Investors should keep a close eye on how the top executives are using excess cash flow and whether they are following the NPV rule.
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