Question

discuss the reasons why net present value is used to make investment decisions.

Answer 1

Net present value is one of many capital budgeting methods used to evaluate potential physical asset projects in which a company might want to invest. Usually, these capital investment projects are large in terms of scope and money, such as purchasing an expensive set of assembly-line equipment or constructing a new building.

Net present value uses discounted cash flows in the analysis, which makes the net present value more precise than any of the capital budgeting methods as it considers both the risk and time variables.

A net present value analysis involves several variables and assumptions and evaluates the cash flows forecasted to be delivered by a project by discounting them back to the present using information that includes the time span of the project (t) and the firm's weighted average cost of capital (i). If the result is positive, then the firm should invest in the project. If negative, the firm should not invest in the project.

The formula for NPV is:

NPV = (Cash inflows from investment) – (cash outflows or costs of investment)

Let's assume Company Apple wants to buy Company Nokia. It takes a careful look at Company Nokia's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of purchasing Company Nokia.

Cost to purchase Company Nokia today: $1,000,000

Present value (PV) of cash flows from acquiring Company Nokia:

Year 1: $200,000

Year 2: $150,000

Year 3: $100,000

Year 4: $75,000

Year 5: $70,000

Year 6: $55,000

Year 7: $50,000

Year 8: $45,000

Year 9: $30,000

Year 10: $10,000

Total: $785,000

Now that we know the total cash flow for the next 10 years (the total cash inflows from the investment), along with the total cost of the investment in Company Nokia, we can use the formula to calculate NPV:

Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000

At this point, management for Company Apple would use the net present value rule to decide whether or not to pursue the acquisition of Company Nokia. Because the NPV is negative, they should say, "No."