Net Present Value Analysis

Perhaps the most commonly employed method for long-term investment project evaluation is called net present-value (NPV) analysis. NPV analysis is the difference between the marginal revenues and marginal costs for individual investment projects, when both revenues and costs are expressed in present value terms. NPV analysis meets all of the criteria for an effective capital budgeting decision rule cited previously. As a result, it is the most routinely applied capital budgeting decision rule. However, the NPV method is only one of four capital budgeting decision rules that might be encountered in practice. Other techniques that are sometimes used to rank capital investment projects include the profitability index or benefit/cost ratio method, the internal rate of return approach, and the payback period. Each of these alternative capital budgeting decision rules, with the possible exception of the payback period, incorporates the essential features of NPV analysis and can be used to provide useful information on the desirability of individual projects. A comparison across methods is useful.

NPV analysis is based on the timing and magnitude of cash inflows and outflows, because traditional accounting data can obscure differences between cash and noncash expenses and revenues, tax considerations, and so on. NPV analysis is commonly used by managers to correctly employ marginal analysis in the capital budgeting process. To see NPV analysis as a reflection of marginal analysis and the value-maximization theory of the firm, recall from Chapter 2 the basic valuation model:

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