Financial Mgt

NET PRESENT VALUE

Mahlaqa Jehanzeb
Lecturer, Department of Management Sciences
Email: Mahlaqa@comsats.edu.pk

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Learning Objectives

Be able to compute the Net

Present Value (NPV) and
understand why it is the best
decision criterion.

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Good Decision Criteria
We need to ask ourselves the following
questions when evaluating capital budgeting
decision rules:
 Does the decision rule adjust for the time value of
money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on
whether we are creating value for the firm?

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Net Present Value
 The difference between the market value of a project
and its cost
 How much value is created from undertaking an
investment?
 The first step is to estimate the expected future cash
flows.
 The second step is to estimate the required return for
projects of this risk level.
 The third step is to find the present value of the cash
flows and subtract the initial investment.

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NPV – Decision Rule

 If the NPV is positive, accept the project

 A positive NPV means that the project is

expected to add value to the firm and will
therefore increase the wealth of the owners.

 Since our goal is to increase owner wealth,

NPV is a direct measure of how well this
project will meet our goal.
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Net Present Value
 The net present value (NPV) is the difference
between the present value of the cash flows (the
benefit) and the cost of the investment (IO):

NPV = PVCF - IO
 In other words, this is the increase in wealth that the
shareholders will receive if the project is accepted
 All projects with NPV greater than or equal to zero
should be accepted

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The NPV: An Example 1
 NPV Calculation
0 1 2 3 4 5
9%

-$1,500 $450 $460 $470 $480 $490

$412.84
$387.17
$362.93
$340.04
$318.47
$ 321.45 = Net Present Value

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The NPV: An Example 2
 NPV Calculation
0 9% 1 2 3 4 5

-$3,000 $755 $855 $955 $1,054 $1,150

$692.66
$719.64
$737.44
$746.68
$747.42
$ 643.83 = Net Present Value

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Test Example
 We will use the following example to demonstrate
the techniques of capital budgeting
 Assume that your company is investigating a new
labor-saving machine that will cost $10,000. The
machine is expected to provide cost savings each
year as shown in the following timeline:
-10,000 2000 250 300 3500 4000
0 0

0 1 2 3 4 5

 If your required return is 12%, should this machine

be purchased? 9
Good luck   

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