Learning Objectives:

1. Define and explain the net present value method.
2. Evaluate the acceptability of an investment project using the net present value (NPV) method.
3. 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 projects cash inflows is compared to the present value of the projects 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 five-years 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.