Question

You are the CFO of a small technology firm. It is difficult for you to raise money from a bank or from other investors, and you only have a limited amount of cash. As long as you apply the NPV rule, you will maximize the returns to your investors.

Answer 1

NPV is net present value. as per NPV rule, any project will be undertaken only if the difference between present value of cash inflows and initial investment is positive i.e. present value of cash inflows is higher than initial investment. Present value of cash inflows is calculated by discounting yearly cash flows by investors' required rate of return.

For example, let's assume a project is available for a year which has initial investment of $10,000 and cash inflow of the project is $15,000. requited rate of return of the investors is 10%.

NPV = [cash inflow/(1+required rate of return)] - initial investment

NPV = [$15,000/(1+0.10)] - $10,000 = ($15,000/1.10) - $10,000 = $13,636 - $10,000 = $3,636

NPV is positive and has excess cash flow of $3,636. so this $3,636 excess cash flow will maximize the returns to investors because it is over and above the investment of $10,000. So $10,000 investment will return $13,636.