In capital budgeting, the NPV method is used to rank investment projects based on their
profitability. The NPV method is the primary capital budgeting decision-making tool to
analyze whether an investment project should be undertaken or rejected. To determine if
an investment project should be undertaken, we need to discount the future cash flows
expected to be generated by this project to the present value using the project’s cost of
capital or hurdle rate.
When a company decides to invest in a new project, they would usually incur in several
initial investment costs (cash outflows) followed by a series of positive cash flows (cash
inflows). For practical purposes, we will assume that a company will make a initial cash
outflow or initial investment in year 0. This cash outflow in year 0 will be added to the
sum of the present value of the future cash flows of the project to obtain the NPV.
Since
the future cash flow generated from a project will tend to vary, we will calculate the
present value of each cash flow individually.
For example, suppose that Coors Co. has been presented with two investment projects to
build a new brewing plant in Boise, Idaho. Project A & B have different expected cash
flows. We assume that these two projects have the same risk and all the cash flows from
these projects occur at the end of each year. Also, both projects have the same cost of
capital, 10%.
The cash flows of Project A&B are presented as follows:
Expected net cash flows
Year
Project A
Project B
0
($1,000)
($1,000)
1
$400
$500
2
$300
$350
3
$500
$400
4
$200
$695