The page discusses net present value (NPV) which is a capital budgeting technique. This topic is covered on the Business Environment Concept (BEC) on the CPA exam.
Capital Budgeting NPV part 1
Capital Budgeting NPV part 2
he net present value method compares the present value of a project’s cash inflows to the present value of its cash outflows. The difference between the present value of these cash flows, called the net present value, determines whether or not a project is an acceptable investment.
When performing net present value analysis, managers usually make two important assumptions. First, they assume that all cash flows other than the initial investment occur at the end of periods. This assumption is somewhat unrealistic because cash flows typically occur throughout a period rather than just at its end; however, it simplifies the computations considerably. Second, managers assume that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the rate used to discount the future cash flows, also known as the discount rate. If this condition is not met, the net present value computations will not be accurate.
Once you have computed a net present value using either of the approaches that we just demonstrated, you’ll need to interpret your findings. For example, because Harper Company’s proposed project has a positive net present value of $8,471, it implies that the company should purchase the new machine. A positive net present value indicates that the project’s return exceeds the discount rate. A negative net present value indicates that the project’s return is less than the discount rate. Therefore, if the company’s minimum required rate of return is used as the discount rate, a project with a positive net present value has a return that exceeds the minimum required rate of return and is acceptable. Conversely, a project with a negative net present value has a return that is less than the minimum required rate of return and is unacceptable.
To improve your understanding of the minimum required rate of return, it bears emphasizing that a company’s cost of capital is usually regarded as its minimum required rate of return. The cost of capital is the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds. If a project’s rate of return is less than the cost of capital, the company does not earn enough to compensate its creditors and shareholders. Therefore, any project with a rate of return less than the cost of capital should be rejected.
The cost of capital serves as a screening device. When the cost of capital is used as the discount rate in net present value analysis, any project with a negative net present value does not cover the company’s cost of capital and should be discarded as unacceptable.
A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values.