Title: The Net Present Value (NPV) Rule — Definition, How to Use It, and Practical Steps
What is the Net Present Value Rule?
– The Net Present Value (NPV) rule states that a manager or investor should accept any project or investment with a positive NPV and reject any project with a negative NPV. When NPV = 0, the project neither increases nor decreases wealth and managers may rely on non‑financial considerations to decide.
– NPV measures how much value a project will add to the firm by converting future expected cash flows into today’s dollars and comparing that present value to the initial investment.
Why NPV matters (intuition)
– Time value of money: A dollar today is worth more than a dollar tomorrow because today’s dollar can be invested to earn returns.
– NPV quantifies the expected increase (or decrease) in shareholder wealth after accounting for the opportunity cost of the capital used (the discount rate).
– If NPV > 0, the project is expected to earn more than the required return and thus increases firm value.
Mathematical definition
– NPV = Σ (CFt) / (1 + r)^t, summed from t = 0 to N,
– where CFt = cash flow at time t (CF0 is usually negative = initial investment),
– r = discount rate (commonly the project’s required return or the firm’s WACC if appropriate),
– N = final year of the project (or the project horizon).
– Interpretation:
– NPV > 0 → accept the project (creates value)
– NPV = 0 → indifferent (project earns exactly the required return)
– NPV 0, accept; if NPV 0).
– Correct application depends on careful estimation of incremental cash flows, selecting an appropriate discount rate, and accounting for risk, taxes, working capital, and terminal values.
– Use sensitivity analysis, consider real options and business strategy, and be mindful of capital constraints and governance issues.
Sources and further reading
– Investopedia — “NPV Rule” (Theresa Chiechi). https://www.investopedia.com/terms/n/npv-rule.asp
– Damodaran, A. — Valuation and corporate finance resources. http://pages.stern.nyu.edu/~adamodar/
– Brealey, R. A., Myers, S. C., & Allen, F. — Principles of Corporate Finance (standard academic text on capital budgeting and NPV).
– CFA Institute — Corporate Finance and Capital Budgeting reading materials.
If you’d like, I can:
– Walk through a customized NPV example using your own project numbers;
– Build an NPV template (Excel layout) you can use to test scenarios; or
– Explain how to select a project‑specific discount rate for a particular business unit or project.