The net present value is an important tool for capital budgeting decision to assess that an investment in a project is worthwhile or not? The net present value of a project is calculated before taking up the investment decision at a given cost of capital also known as the discount rate.
NPV = Sum of present values of all cash inflows – Initial investment
From the above formula we can see that there are two sections of the formula, i.e. the present value of cash inflows and the investment. The investment is an outflow that is required to initiate a project that will result periodic cash inflows in future. The NPV will add the out flows and PV of inflows to get a net figure. If the net figure is negative then the project is not worthy and if the NPV is positive then the project is worthy.
The NPV is also considered as a best decision tool among other tools like payback period and IRR that rule different decisions or confused decisions. In case there are more than one projects, the decision taken based on NPV is always better and correct than IRR and payback period.
Under different circumstances the decision rule will be changed for both IRR and Payback period but NPV rules the same decision under any circumstances. In state of capital rationing, mutually exclusive projects are selected based on the highest positive NPV, whereas the IRR can be higher in terms of percentage but return might be very lower in terms of absolute terms.
Profitability index is an additional tool to filter multiple projects that are having positive NPVs. The higher this index is the more the project is worthy. It is calculated as follows
Profitability index = Present value of all cash inflows / Investment
To learn more about NPV see this video:
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