Net Present Value

The net present value (NPV) may be defined as the summation of the present values of the cash proceeds in each year minus the summation of present values of the net cash outflows in each year.

The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative.

NPV > Zero, Accept the project

NPV < Zero, Reject the project

Zero NPV implies that the firm is indifferent between accepting or rejecting the project.

As a decision criterion, this method can be used to make a choice between mutually exclusive projects. On the basis of NPV method, the various proposals would be ranked in order of the net present values. The project with the highest NPV would be assigned the first rank, followed by others in the descending order.

The most significant advantage of this method is that it recognises the time value of money. It also takes into account the total benefits arising out of the proposal over its life-time. This method is useful for the selection of mutually exclusive projects. This method of asset selection helps in achieving the objective of the maximisation of the shareholders wealth. When the present value exceeds the outlay, that is the NPV >Zero, the return would be higher than expected by the investors. It would, therefore, lead to an increase in share prices and maximising the shareholders wealth.