Net Present Value Rule

What it is

The Net Present Value (NPV) rule states that a firm should accept investments or projects only if they produce a positive NPV—meaning the present value of expected cash inflows exceeds the initial outlay. Projects with negative NPV should be rejected. A project with NPV = 0 is expected to neither increase nor decrease firm value; nonfinancial considerations may determine whether to proceed.

Why it matters

NPV directly measures how a project affects shareholder wealth by accounting for:
* Timing of cash flows (time value of money)
* Scale and duration of expected inflows and outflows
* The required return or discount rate reflecting opportunity cost and risk

Accepting positive-NPV projects increases firm value; rejecting negative-NPV projects preserves capital.

How NPV is calculated

NPV is computed by discounting each expected future cash flow back to present value and subtracting the initial investment:

NPV = Σ (CFt / (1 + r)^t) − Initial investment

Where:
* CFt = cash flow at time t
* r = discount rate (commonly the company’s weighted average cost of capital, or a project-specific required return)
* T = project horizon

A discounted cash flow (DCF) model is the typical method for projecting and discounting the cash flows.

Decision rule

• NPV > 0: accept (adds value)
• NPV < 0: reject (destroys value)
• NPV = 0: indifferent on financial grounds; consider strategic or intangible benefits

For mutually exclusive projects, choose the one with the highest positive NPV. Under capital rationing, additional metrics (e.g., profitability index) may be used to prioritize projects.

Short numerical example

Initial investment = $100,000
Expected cash flows = $40,000 each year for 3 years
Discount rate = 8%

Present values:
* Year 1: 40,000 / 1.08 = 37,037
* Year 2: 40,000 / 1.08^2 = 34,285
* Year 3: 40,000 / 1.08^3 = 31,752

Sum PV = 103,074 → NPV = 103,074 − 100,000 = 3,074 (positive) → accept.

Limitations and caveats

• Discount rate selection: Using an inappropriate rate (too high or too low) can misstate project value. Use WACC for company-wide projects or a project-specific required return for investments with different risk.
• Estimation risk: NPV depends on cash flow forecasts, which can be uncertain. Sensitivity analysis, scenario analysis, or Monte Carlo simulation can help.
• Capital constraints: Even positive-NPV projects may be postponed or rejected if the firm faces liquidity issues or must prioritize debt repayment.
• Corporate governance and behavioral biases: Management may ignore NPV criteria due to incentives, empire-building, or miscalculation.
• Intangibles and strategic value: Some projects with zero or slightly negative NPV may be undertaken for strategic reasons (market entry, regulatory compliance, learning, or future options) but these should be explicitly valued when possible.

Key takeaways

• The NPV rule is the gold standard for capital budgeting because it measures expected contribution to firm value after accounting for time and risk.
• Use a rigorous DCF framework, choose an appropriate discount rate, and test assumptions.
• Consider liquidity, strategic objectives, and governance realities alongside NPV when making final decisions.