There are basically two discounted cash flow (DCF) methods of investment appraisal: the net present value (NPV) and the internal rate of return (IRR) methods. This article would take a look at the first one, the NPV investment appraisal method.
The NPV investment appraisal method is a straightforward approach that it works on a fundamental principle, whenever the money got out of the investment is equal to or greater than the money put in, the investment is regarded as worth undertaking. Thus, the decision rule of the NPV method would be accept all investments with a zero or a positive net value and reject all those with a negative net value. Because the method is called discounted cash flow approach, the NPV method takes the time value of money into considerations.
This formula expresses the sum of the investment discounted future cash flows. According to the decision role, if we calculated the NPV which has a positive or zero value, the company should invest in the project; if the NPV has a negative value, it should not invest.
In this article, we get the idea of how the NPV investment appraisal method works and how it calculates. In fact, in order to simplify the analysis, we should specify several assumptions at first, we will list them after we get the basic idea of another method, the IRR method. And also we will try to compare these two methods under some relaxation of the project independence assumptions.
Lumby, S. (1981) Investment appraisal and related decisions. Hong Kong: Nelson.