HKSM

A technique that computes the present net amount of future cash inflows and outflows by discounting them using an assumed interest or inflation rate, helping determine whether a project adds value today.

Key Points

• Uses an assumed interest or inflation (discount) rate to convert future cash flows into present values.
• Decision rule: accept projects with NPV greater than zero; when options are exclusive, choose the highest positive NPV.
• Captures the time value of money and can reflect risk through the chosen discount rate.
• Results depend on assumptions about cash flow size, timing, and discount rate; sensitivity analysis is recommended.

Example

A project needs an initial investment of $100,000 and is expected to return $60,000 in year 1 and $60,000 in year 2. Using a 10% discount rate (assumed interest), PV of benefits is $60,000/1.10 + $60,000/1.10^2 = $54,545 + $49,587 = $104,132. NPV = $104,132 - $100,000 = $4,132. Because NPV is positive, the project adds value.

PMP Example Question

Which statement best describes how Net Present Value (NPV) should be used in project selection?

1. NPV discounts future cash flows at an assumed rate and favors the option with the greatest positive NPV.
2. NPV ignores the time value of money and focuses on how quickly costs are recovered.
3. NPV is identical to IRR and always yields the same ranking.
4. NPV cannot compare mutually exclusive projects because it is not a monetary measure.

Correct Answer: A — NPV discounts future cash flows and selects the highest positive NPV

Explanation: NPV converts future cash flows to present value using an assumed discount rate (interest or inflation) and the preferred choice is the alternative with the largest positive NPV.