Topics: Net present value, Discounted cash flow, Time Pages: 1 (314 words) Published: May 2, 2007
NPV is short for Net Present Value and it makes difference between the present value and cost of a project. In addition, NPV takes into account all cash flows through out the whole life of the projects, as well as the time value of money. And it compares like with like as all inflows and outflows are discounted to today¡¯s date. Also, the cost of capital is very unlikely to be changed over a period of time. To judge if the NPV is good, we should see the value of it, and the rule is the high the better. But, there is a rule for NPV, which is When NPV is greater than 0 we accept it, when the NPV is less than 0 we reject it. What is more, the net present value rule states that managers increase shareholders¡¯ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value. When choosing between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project and, from those options that have a positive NPV, choose the one whose NPV is highest. In Fisher¡¯s separation theorem, it states that companies can make their investment decisions independently of individual shareholders¡¯ consumption decision by using the NPV rule. Moreover, the formula of NPV is NPV=PV-required investment, and there is a traditional way to calculate NPV, which is to use DCF, but, with real investment options DCF is not the appropriate way of calculating NPV. Sometimes, sunk costs are thought to be considered when calculating NPV, but, this is improper because sunk costs are past and irreversible outflows, e.g. cost of research for a new project. Furthermore sunk costs remain the same whether or not you accept the project. Therefore, they do not affect project NPV.
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