The capital investment opportunities companies have should evaluated by undertaking any investments in which the present value of the cash inflows exceeds the present value of the cash outflows.
Companies raise capital and invest in assets. Depending on what line of business a company is engaged in, its investments take the form of projects, factories, new products, divisions, machinery, or equipment. Some investments are not quite as physical, such as investing in personnel and software. The process of investing in assets is sometimes called capital budgeting. Whether a company should make a particular capital investment depends on whether that investment creates value for the shareholders. Capital investments typically involve the outlay of funds, followed by a period of cash flows, perhaps some being negative but hopefully most being positive. Some projects could involve the generation of cash at the start followed by cash outflows later, such as being paid first to provide a product or service that will incur costs while providing it. Regardless of the case, however, a capital investment should be undertaken if and only if it adds value. Value is added if the present value of the inflows exceeds the present value of the outflows. The present value of the inflows minus the present value of the outflows is typically called the net present value.
The concept of net present value is the idea that you determine the present value of the cash flows over the life of the contract and subtract the initial outlay. Because the initial outlay, by definition, occurs today, we do not explicitly find its present value. The initial outlay is its present value. But the term net present value has been around so long that it is standard terminology, and we have to use it. But what we are doing is simply finding the present value of all cash flows of a project. Some cash flows will be outflows, and some will be inflows. Some will occur today, some will occur later. But the general idea is the same: if the present value of all cash flows, positive and negative, is positive, then the project adds value.
Certain other decision criteria, such as payback period, profitability index, and internal rate of return are widely used in practice. These techniques will sometimes lead to the correct decision but not always. The correct decision is always the one that adds value to the shareholders. Net present value is the only criterion guaranteed to lead to the correct decision all of the time.
Back to previous page
|My official LSU home page||To LSU Department of Finance Home Page||To E. J. Ourso College of Business Administration Home Page||To LSU Home Page|
Last updated: January 9, 2011