In what types of situations would capital budgeting decisions be made solely on the basis of project's net present value (NPV)? Identify potential reasons that might drive higher NPV for a given project

Capital budgeting is a process companies use to decide on which projects to invest in. “The net present value method uses the investor's required rate of return to calculate the present value of future cash flow from the project. The rate of return used in these calculations depends on how much it cost for the investor to borrow money or the return that the investor wants for his own money.”

“Say that firm XYZ Inc. is considering two projects, Project A and Project B, and wants to calculate the NPV for each project.

• Project A is a four-year project with the following cash flows in each of the four years: $5,000, $4,000, $3,000, $1,000.
• Project B is also a four-year project with the following cash flows in each of the four years: $1,000, $3,000, $4,000, $6,750.
• The firm's cost of capital is 10 percent for each project, and the initial investment is $10,000.

The firm wants to determine and compare the net present value of these cash flows for both projects. Each project has uneven cash flows. In other words, the cash flows are not annuities.

Following is the basic equation for calculating the present value of cash flows, NPV(p), when cash flows differ each period:

NPV(p) = CF(0) + CF(1)/(1 + i)t + CF(2)/(1 + i)t + CF(3)/(1 + i)t + CF(4)/(1 + i)t

Where:

• i = firm's cost of capital
• t = the year in which the cash flow is received
• CF(0) = initial investment

To work the NPV formula:

• Add the cash flow from Year 0, which is the initial investment in the project, to the rest of the project cash flows.
• The initial investment is a cash outflow, so it is a negative number. In this example, the cash flows for each project for years 1 through 4 are all positive numbers.

Tip: You can extend this equation for as many time periods as the project lasts.

To calculate the NPV for Project A:

NPV(A) = (-$10,000) + $5,000/(1.10)1 + $4,000/(1.10)2 + $3,000/(1.10)3 + $1,000/(1.10)4

= $788.20

The NPV of Project A is $788.20, which means that if the firm invests in the project, it adds $788.20 in value to the firm's worth.”

Carlson, R. (2019). Net Present Value (NPV) in Capital Budgeting. Retrieved August 13, 2020, from https://www.thebalancesmb.com/net-present-value-npv-as-a-capital-budgeting-method-392915