Net Present Value
The net present value (NPV) of a project consists of comparison of the present value of all the expected net cash flows (discounted using firm's cost of capital as interest rate) to the initial cost of the project. If the present value of the cash flows exceeds the cost, the proposal meets the evaluation criterion, i.e., the value of the firm will be increased by making the investment. In other words, the rate of return on capital expenditure exceeds firm's cost of capital, and thus future profits will be higher if the investment is made. The rate of return is not determined explicitly, therefore, it is referred as implicit rate of return.
The NPV can be written as follows
NPV= ∑nt=1 [Rt/(1+k)t] -c0
Where Rt refers to the estimated net cash flow from the project in each of the n years considered, k is the risk adjusted discount rate, and Co is the initial cost of the project. If NPV is positive, the firm should undertake the project and should not undertake it if it is negative.
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