Introduction to Financial Management

across the entire firm. The differences of the cash flows in the base and the alternative

scenario are the incremental cash flows.

The incremental cash flows estimated here are typically uncertain, and we have to take

into account that some cash flows are certain, whereas others depend on the state of the

economy. Taxes on the gain from the sales of an old asset or the tax savings on a loss

must be considered when determining the amount of the initial investment of a new

asset.

Net Present Value (NPV)

One investment appraisal measure is the net present value, or NPV. The NPV of a

project is the present value of all future cash flows produced by an investment, less the

initial cost of the investment. A project creates wealth if it generates cash flows over

times that are worth more in present value terms than the initial set-up cost-Net preset

value (NPV).

In determining whether to accept or reject a particular projected, the NPV decision rule

is

Net Cash Flow = Cash Inflow - Cash Outflow
Present Value = Net Cash Flow*Discounting factor
Net Present value =Sum of Present Value - Initial Investment cost
Accept a project if its NPV > 0;
Reject a project if its NPV < 0; 1
It is optimal to make decisions that generate positive net present values of their
incremental cash flows. If there are more than two alternatives, it is optimal to choose the
alternative that generates the highest NPV.

The point is to see that the project covers her liability e.g. from the bank loan completely.

Hence, if shareholders take positive NPV projects, then they can consume more than they

could without the project. If they accept negative NPV projects, they have to cut

consumption in order to be able to finance the project.

NPV analysis is always forward- looking and must incorporate opportunity costs and

ignore sunk costs but appropriate formulas should be used to charge overhead expenses

to various projects and department.