NPV = (($300,000 / 1.1) + ($1000,000 / (1.1)2 + ($400,000 / (1.1)3) – $1000,000
NPV = +$399,650

Or alternatively:

The NPV calculation for Project B is:

The annual cash flow stream is similar therefore annuity factor is used.

Above both projects are acceptable. If one of them has to be selected than project B should be preferred because of higher net present value.

The rational behind acceptance criterion is the same as that behind the internal rate of return method. If the required rate of return is the return, the investors expect the firm to earn on the investment proposal, and the firm accepts the proposal with net present value greater than zero, the market price of the stock will rise. Again the firm is taking on a project with a return greater than that necessary to leave the market price of the stock unchanged.

Determining Relevant Cash Flows

Determination of relevant cash flows for discounting is perhaps the most difficult job in capital budgeting. It requires good analytical and conceptual skills on the part of a financial manager. Relevant cash flows often called free cash flows and are ascertained after complex computations.

Treatments of depreciation and taxation require theoretical and practical understanding of accounting and finance. As soon as free cash flows are determined with a quite a reasonable certainty calculation of Net Present Value becomes almost a trouble-free job.

Example:

A company earns a contribution of $ 75,000 each year over a Project’s life. Depreciation on straight-line basis is $ 25,000 each year and tax rate is 35%.

Required: To determine the relevant cash flow for each year.

Solution:

Net Present Value is a widely used evaluation technique in capital budgeting due to its practical implications and investors’ preferences because it takes into account only cash returns discounted at investors required rate of return which covers the whole period of the project or proposal.

In brief, the present value method is a theoretically correct technique for the selection of investment projects. Nevertheless, it has certain limitations also.

In the first place, it is difficult to calculate as well as understand and use in comparison with the pay back method or even the accounting rate of return method. This, of course, is a minor flaw. The second, and more serious problem associated with the present value method, involves the calculation of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation for the present values because different discount rates will give different present values. The relative desirability of a proposal will change with the change in discount rate.