Question

What is the intuition behind the NPV capital budgeting framework?

Answer 1

Using appropriate decision-making models when analyzing the costs and benefits of long-term investment plans is essential. The viability of capital investments can be ascertained using the net present value (NPV) method.

The NPV framework is a discounted cash flow method. The method compares the present value of all cash inflows related with the proposed project against the present value of all project outflows. If inflows are adequate to cover all operating costs and financing costs, the project enhances the wealth of shareholders.

The NPV method provides simple criteria for choosing or rejecting investment projects. Projects with positive NPVs qualify for selection because their benefits, in terms of target rates of returns, exceed costs. Investments yield zero NPV when they have equal benefits and costs and the rate at which NPV is 0, is called Internal Rate of Return (IRR). This affords businesses the flexibility to accept or reject such investments. Negative NPVs, on the other hand, are loss-making investments that must shunned completely.

NPV can be used to rank mutually exclusive or competing investments to determine the ones that fall within the budgeted limits of the business. For example, a business entity may have a viable project that is way beyond its financial capabilities. Undertaking such an investment would not add any value to the business and will only lead to unnecessary burden. NPV rankings provide mechanisms for detecting such discrepancies.