The Use of Net Present Value (NPV) Method in Capital Budgeting
Decisions  Discounted Cash Flows:
Learning Objectives:
 Define and explain the net present value
method.
 Evaluate the acceptability of an
investment project using the net present value (NPV) method.
 What are the advantages and
disadvantages of NPV method?
Two approaches to making capital budgeting
decisions use discounted cash flows. One is the net present value method
(NPV),
and other is the internal rate of return method (also called the time
adjusted rate of return method). The net present value method is discussed
on this page.
Definition and Explanation of Net Present
Value (NPV) Method:
Under the net present value
method, the present value of a project's cash inflows is compared to the present
value of the project's cash outflows. The difference between the present value
of these cash flows is called "the net present value". This net present value
determines whether or not the project is an acceptable investment. To illustrate
consider the following data.
Example 1:
Harper company is contemplating the purchase of a machine capable of
performing certain operations that are now performed manually. The machine will
cost $5,000, and it will last for five years. At the end of fiveyears period
the machine will have a zero scrap value. Use of the machine will reduce labor
costs by $1,800 per year. Harper company requires a minimum pretax return of 20%
on all investment projects.
Should the machine be purchased? Harper company must determine whether a cash
investment now of $5,000 can be justified if it will result in an $1,800
reduction in cost each year over the next five years. It may appear that the
answer is obvious since the total cost savings is $9,000 (5 × $1800). However,
the company can earn a 20% return by investing its money elsewhere. It is not
enough that the cost reductions cover just the original cost of the machine.
they must also yield at least 20% return or the company would be better off
investing the money elsewhere.
To determine whether the investment is desirable, the stream of annual $1,800
cost savings is discounted to its present value and then compared to the cost of
the new machine. Since Harper company requires a minimum return of 20% on all
investment projects, this rate is used in the discounting process and is called
the discount rate. This analysis is shown below.
Initial Cost
Life of the project (year)
Annual cost savings
Salvage value
Required rate of return 
$5,000
5
$1,800
0
20% 
Item 
Years 
Amount of cash flows 
20% Factor 
Present value of cash
flows 
Annual cost savings
Initial investmentNet present value

1―5
Now 
$1,800
(5,000) 
2.991*
1,000 
$ 5,384
(5,000)

$ 384
====== 
*Present value of an annuity of $1 in arrears. (From
Future Value and Present
Value Tables page  Table 4)
According to this analysis, Harper company should
purchase the new machine. The present value of the cost savings is $5,384,
as compared to a present value of only $5,000 for the required investment
(cost of the machine). Deducting the present value of the required
investment from the present value of the cost savings a net value of $384.
Whenever the net present value is zero or greater, as in our example, an
investment project is acceptable. Whenever the net present value is negative
an investment project is not acceptable. In sum:
If the net present value is 
Then the project is 
Positive 
Acceptable since it
promises a return greater than the required rate of return 
Zero 
Acceptable, since it
promises a return equal to the required rate of return. 
Negative 
Not acceptable,
since it promises a return less than the required rate of return 
A full interpretation of the solution is as
follows:
The new machine promises more than the required 20% rate of return. This is
evident from the positive net present value of $384. Harper company could
spend up to $5,384 for the new machine and still obtain the minimum 20%
required rate of return. The net present value of $384, therefore, shows the
amount of "cushion" or "margin of error". One way to look at this is that
the company could underestimate the cost of the new machine by up to $384,
or overestimate the net present value of the future cash savings by up to
$384, and the project would still be financially attractive.
Emphasis on Cash Flow:
In capital budgeting decisions, the focus is on
cash flows and not on accounting net income. The reason is that accounting net
income is based on accruals that ignore the timing of cash flows into and out of
an organization. From a capital budgeting standpoint, the timing of cash flows
is important, since a dollar received today is more valuable than a dollar
received in the future. Therefore, even though accounting net income is useful
for many things, it is not ordinarily used in discounted cash flow analysis.
Instead of determining accounting net income, the manager concentrates on
identifying the specific cash flows of the investment project.
What kind of cash flows should the manager look
for? Although the specific cash flows will vary from project to project, certain
type of cash flows tend to recur as explained in the following paragraphs.
Typical Cash Out Flows:
Most projects will have an immediate cash
outflows in the form of an initial investment or other assets. Any salvage value
realized from the sale of the old equipment can be recognized as a cash inflow
or as a reduction in the required investment. In addition, some projects require
that a company expand its
working capital. When a company takes on a new project, the balances in the
current assets will often increase. For example, opening a new Nordstrom's
department store would require additional cash in sales registers, increased
accounts receivable for new customers, and more inventory to stock the shelves.
These additional working capital needs should be treated as part of the initial
investment in a project. Also, many projects require periodic outlays for
repairs and maintenance and for additional operating costs. These should all be
treated as cash outflows for capital budgeting purposes.
Typical Cash Inflows:
On the cash inflow side, a project will
normally either increase revenues or reduce costs. Either way, the the amount
involved should be treated as a cash inflow for capital capital budgeting
purposes. Notice that so for as cash flows are concerned, a reduction in costs
is equivalent to an increase in revenues. Cash inflows are also frequently
realized from salvage of equipment when a project ends, although the company may
actually have to pay to dispose of some low  value or hazardous items. In
addition, any working capital that was tied up in the project can be released
for use elsewhere at the end of the project and should be treated as a cash
inflow at that time. Working capital is released, for example, when a company
sells off its inventory or collects its receivables.
The following types of cash flows are common in
business investment projects.
Cash out flows: 
Cash inflows: 
 Initial investment (including installation costs).
 Increased working capital needs for project.
 Repairs and maintenance.
 Incremental operating costs.

 Incremental revenues
 Reduction in costs
 Salvage value
 Release of working capital

Recovery of the Original Investment:
When computing the present value of a
project, depreciation is not deducted for two reasons. First, depreciation
is not a current cash outflow. As discussed above, discounted cash flow
methods of making capital budgeting decisions focus on cash flows. Although
depreciation is used to compute not income for financial statements, it is
not relevant in an analytical framework that focuses on cash flows.
A second reason for not deducting depreciation
is that discounted cash flow methods automatically provide for return of the
original investment, thereby making a deduction for depreciation
unnecessary. To demonstrate this point, consider the following example:
Example 2:
Carver Hospital is considering the purchase
of an attachment for its Xray machine that will cost $3,170. The attachment
will be usable for four years, after which time it will have no salvage
value. It will increase net cash inflows by $1,000 per year in the Xray
department. The hospital's board of directors has instructed that no
investments are to be made unless they have an annual return of at least
10%. A present value analysis of the
desirability of purchasing the Xray attachment is presented below:
Initial cost
Life of the project (years)
Annual net cash inflow
Salvage value
Required rate of return 
$3,170
4
$1,000
0
10% 
Item 
Year(s) 
Amount of Cash Flow 
10% Factor 
Present Value of Cash Flows 
Annual net cash inflow
Initial investment
Net present value 
1  4
Now 
$1,000
(3,170) 
3.170*
1.000 
$3,170
(3,170)

$ 0
====== 
Notice that the attachment promises exactly
a 10% return on the original investment, since the net present value is zero
at a 10% discount rate. Each annual
$1,000 cash inflow arising from use of the attachment is made up of two
parts. One part represents a recovery of a portion of the original $3,170
paid for the attachment, and the other part represents a return on this
investment. The breakdown of each year's $1,000 cash inflow between recovery
of investment and return on investment is shown below:
Carver Hospital  Breakdown of Annual Cash
Inflows

(1) 
(2) 
(3) 
(4) 
(5) 
Year 
Investment outstanding during the year 
Cash Inflow 
Return on investment
(1) × 10% 
Recovery of investment during the year
(2)  (3) 
Unrecovered investment at the end of the
year
(1)  (4) 
1 
$3,170 
$1,000 
$317 
$683 
$2,487 
2 
2,487 
1,000 
249 
751 
1,736 
3 
1,736 
1,000 
173 
827 
909 
4 
909 
1,000 
91 
909 
0 

 
 
 
 
 
Total investment recovered 



$3,170 

The first year's $1,000 cash inflow
consists of a $317 interest return (10%) on the $3,170 original investment,
plus a $683 return of that investment. Since the amount of unrecovered
investment decreases over the four years, the dollar amount of the interest
return also decreases. By the end of the fourth year, all $3,170 of the
original investment has been recovered. Simplifying Assumptions:
Two simplifying assumptions are usually
made in net present value analysis:
 The first assumption is that all cash
flows other than the initial investment occur at the end of the period.
This is somewhat unrealistic in that cash flows typically occur throughout
a period rather than just at its end. The purpose of this assumption is
just to simplify computations.
 The second assumption is that all cash
flows generated by an investment project are immediately reinvested at a
rate of return equal to the discount rate. Unless these conditions are
met, the net present value computed for the project will not be accurate.
To illustrate, we used a discount rate of 10% for Carver Hospital in
example 2. Unless the funds released each period are immediately
reinvested at a 10% return, the net present value computed for the Xray
attachment will be misstated.
Choosing a Discount Rate in Capital Budgeting
Decisions:
A positive net present value
means that the project's return exceeds the discount rate. A negative
net present value means that the project's return is less than the
discount rate. Therefore, if the company's minimum required rate of return
is used as the discount rate, a project with a positive net present value is
accepted and a project with a negative net present value is unacceptable.
What should be a company's rate of return?
The company's cost of capital is usually regarded as the minimum
required rate of return. The cost of capital is the average rate of return the
company must pay to its long term creditors and to shareholders for the use of
their funds. The cost of the capital is the minimum requirement of return
because if a project's rate of return is less than the cost of capital, the
company does not earn enough to compensate its creditors and shareholders.
Therefore any project with a rate of return less than the cost of capital should
not be accepted.
The cost of capital serves as a screening device in
net present value analysis. When the cost of capital is used as the discount rate,
any project with a negative net present value does not cover the company's cost
of capital and should be discarded as unacceptable.
An Extended Example of the Net Present Value Method:
To conclude our discussion of the net present
value method, we present below an extended example of how it is used to analyze
investment proposals. This example will also help to tie together (and to
reinforce) many of the ideas developed thus far.
Example 3:
Under a special arrangement, Swinyard company
has an opportunity to market a new product in the western united states for a
fiveyear period. The product would be purchased from the manufacturer, with
Swinyard company responsible for all costs of promotion and distribution.
The licensing arrangement could be renewed at the end of the fiveyear period.
After careful study, Swinyard company has estimated the following costs and
revenues for the new product:
Cost of
equipment needed 
$60,000 
Working
capital needed 
100,000 
Overhaul of
the equipment in four years 
5,000 
Salvage
value of the equipment in five years 
10,000 
Annual
revenues and costs: 

Sales
revenue 
200,000 
Cost of
goods sold 
125,000 
Out of pocket
operating costs (for salaries, advertising, and other direct costs) 
35,000 
At the end of five year period, the
working capital would be released for investment elsewhere if Swinyard
decides not to renew the licensing arrangement. Swinyard company uses a
14% discount rate. Would you
recommend the new product be introduced?
This example involves a variety of cash
inflows and cash outflows. The solution is given below:
Sales revenues 
$200,000 
Less cost of goods sold 
125,000 
Less out of pocket costs for salaries, advertising etc. 
35,000 

 
Annual net cash inflows 
40,000 

====== 
Item 
Years 
Amount of Cash Flows 
14% Factor 
Present Value of Cash Flows 
Purchase of
equipment 
Now 
$ (60,000) 
1.000 
$ (60,000) 
Working
capital needed 
Now 
(100,000) 
1.000 
(100,000) 
Overhaul of
equipment 
4 
(5,000) 
0.592* 
(2,960) 
Annual net cash
inflows from sales of the product line 
1  5 
40,000 
3.433** 
137,320 
Salvage value
of the equipment 
5 
10,000 
0.519* 
5,190 
Working capital
released 
5 
100,000 
0.519* 
51,900 




 
Net present
value 



$31,450 




====== 
*From
Future Value and Present
Value Tables page  Table 3
**From
Future Value and Present
Value Tables page  Table 4
Notice particularly how the working capital is handled in this example. It
is counted as a cash outflow at the beginning of the project and as a cash
inflow when it is released at the end of the project. Also notice how the
sales revenues, cost of goods sold, and out of pocket costs are handled. Out
of pocket costs are actual cash outlays for salaries, advertising, and other
operating expenses. Depreciation would not be an out of pocket cost, since
it involves no current cash outlay.
Since the overall net present value is positive, the new product should be
added assuming the company has no better use for the investment funds. 