Net Present Value (NPV)

The net present value (NPV) of an investment is the present value of all the expected future cash flows less the initial investment. If the NPV is positive, then the investment recovers all of the initial investment and more, while taking into account the time value of the cash flows (see entry for Time Value of Money). If the NPV is negative, the investment does not recover all of the initial investment, taking time value of the cash flows into account. A common decision rule is to accept a project or investment only if its NPV is greater than or equal to zero.

Some examples will help illustrate the concept. Consider a new health care facility. It will cost $100 million to develop and launch a new facility, and the net cash flows are expected to be $30 million per year for 5 years. If the corporate cost of capital is 9%, is it a good investment? The cash flows are as follows:

The present values are

• Year 0: –100.00
• Year 1: 30/(1.09) = 27.52
• Year 2: 30/(1.09)2 = 25.25
• Year 3: 30/(1.09)3 = 23.17
• Year 4: 30/(1.09)4 = 21.25
• Year 5: 30/(1.09)5 = 19.50

The total of these is the net present value and is -$100 + $116.69 = $16.69.

This means the parent corporation would be $16.69 million better off by launching the new facility than not launching it.

A special case of the NPV decision rule is for zero NPV investments. An investment has a zero NPV if its cost exactly equals the present value of its benefits. In other words, a zero NPV investment is fairly priced. Should a company invest in zero NPV projects? The answer is “It depends.” Just about all investments in marketable securities—from stocks, to bonds, to options, to futures contracts—are zero NPV investments. If the company has positive NPV projects, then certainly it should invest in those first. If it runs out of positive NPV projects, then its owners should be indifferent between the firm investing in a zero NPV project and just returning the money that would be spent to the owners—either through a dividend or perhaps a stock repurchase. However, the company should never invest in a negative NPV project. It is important to note that this applies only to for-profit concerns. A not-for-profit firm may legitimately invest in negative NPV projects if doing so furthers its mission—not-for-profits are not constrained to maximize NPV, as are for-profit concerns.