Capital Budgeting Evaluation Techniques^119
n = life of the project
k = cost of capital used as the discount rate
Here C0 is the initial investment we are making into the project and the rest is the
present value of the cash flows we are expecting in the future. So NPV is the difference
between the two at the expected rate of return.
With NPV the acceptance rule is
NPV > 0 Accept
= 0 Indifferent
< 0 Reject
If the NPV is greater than zero we accept the project because we are getting a rate of
return which exceeds our desired rate of return, if it is equal to zero we may or may not
accept the project as we are getting a return which is exactly equal to our desired rate
of return, and if it is less than zero we reject the project proposal because the rate of
return we are getting is less than our desired rate of return.Features of Net Present Value
Two features of the net present value method to be emphasised :- The NPV method is based on the assumption that the intermediate cash inflow of
the project is reinvested at a rate of return equal to the firm's cost of capital. - The NPV of a simple project monotonically decreases as the discount rate
increases; the decrease in NPV, however, is at a decreasing rate.
Evaluation
Conceptually sound, the net present value criterion has considerable merits:
l It takes into account the time value of money.
l It considers the cash flow stream in its entirety.
l It squares neatly with the financial objective of maximisation of the wealth of
stockholder. The net present value represents the contribution to the wealth of
stockholders.
l The net present value of various projects, measured as they are in today's rupees,
can be added. For example, the present value of package consisting of two projects
A and B, will simply be the sum of the net present value of these projects individually:
NPV (A+B) = NPV (A) + NPV (B)
The additivity property of net present value ensures that a poor project (one which has