NPV Rule

The Net Present Value Rule says that if the project under review has zero or positive net present value the company should invest in the project.

In general terms the net present value of an investment project is the sum of its net discounted future cash flows which is expressed in a formula like this:

Sum of this cash flow series for all values from time period = 0 > At/(1+r)t > n

A is the cash flow in period t, and r is the discount rate and n is the number of periods.

Notice that it is assumed that the discount rate "r" remains constant over the lifetime of the investment appraisal. This may not hold true for the entire duration of the project.

And when the discount rate used is the rate of return available in the capital market, then it becomes even more obvious that if the Net Present Value is negative at this rate, then:

A negative NPV project is unacceptable because it indicates that the project makes a loss relative to a capital market investment.

A negative NPV project is unacceptable because it produces a return less than available for the same risk in the capital market.

A negative NPV project is unacceptable because it will not generate enough cash flow to repay the financial costs.

Software Links

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Reference Pages

NPV

Discounted Cash Flow

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