What is the net present value rule?
The rule of net present value is the idea that business leaders and investors should only invest in projects or engage in transactions that have a positive net present value (NPV). They should avoid investing in projects with a negative net present value. It is a logical outgrowth of the theory of net present value.
Understanding net present value
Understanding the net present value rule
According to the theory of net present value, investing in something that has a net present value greater than zero should logically increase the profits of a business. In the case of an investor, the investment should increase the wealth of the shareholder. Companies can also participate in neutral NPV projects when they communicate to shareholders goodwill or ongoing investments.
Although most companies adhere to the net present value rule, there are circumstances where this is not a factor. For example, a company with significant debt problems may abandon or postpone carrying out a project with a positive NPV. The company can take the opposite direction by redirecting capital to resolve an immediately pressing debt problem. Poor corporate governance can also cause a company to ignore or miscalculate the NPV.
How the net present value rule is used
The net present value, commonly seen in capital budgeting projects, represents the time value of money (TVM). The time value of money is the idea that future money has less value than the capital currently available, because of the earning potential of current money. A business will use a discounted cash flow (DCF) calculation, which will reflect the potential wealth change for a particular project. The calculation will take into account the time value of money by discounting the projected cash flows to the present, using the weighted average cost of capital (WACC) of a business. The NPV of a project or investment is equal to the present value of the net cash inflows that the project is expected to generate, minus the initial capital required for the project.
During the company’s decision-making process, it will use the net present value rule to decide whether or not to continue a project, such as an acquisition. If the calculated NPV of a project is negative (< 0), the project is expected to result in a net loss for the company. As a result, and according to the rule, the company should not pursue the project. If a project's NPV is positive (> 0), the business can expect a profit and should consider moving ahead with the investment. If the NPV of a project is neutral (= 0), the project should not result in a significant gain or loss for the company. With a neutral NPV, management uses non-monetary factors, such as goodwill, to decide on the investment.