Like the internal rate of return method, the net present value method is a discounted cash flow approach to capital budgeting. With the present value method, all cash flows are discounted to the present value, using the required rate of return. The net present value of an investment proposal is where k is the required rate of return. If the sum of these cash flows discounted is zero or more, the proposal is accepted if not, it is rejected.
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Another way to express the acceptance criterion is to say that the project will be accepted if the present value of the cash income exceeds the present value of the cash outflows. The explanation that underlies the acceptance criterion is the same as the one that supports the internal rate of return method. If the required rate of return is the return that investors expect the company to obtain from the investment proposal, and the company accepts a proposal with a net present value greater than zero, the market price of the share must go up Again, the organization is accepting a project with a greater than needed to leave without performance change the price of shares on the market.
Again, the problem can be solved by means of a computer, a calculator or by consulting the appropriate table of present value. When using table B because an annuity is involved, we find that the appropriate discount factor is 3.6048 and we multiply $ 5 700 by that factor to obtain $ 20 547. By subtracting the initial outlay of $ 18,000, we obtain $ 2 547. Since the present value net of this proposal is greater than 0, the proposal must be accepted, using the present value method.
With the internal rate of return method, we are provided with the cash flows and we clear the discount rate that equals the present value of the cash income with the present value of the expenses. Then we compare the internal rate of return with the rate of return required to determine whether the proposal should be accepted. With the present value method, we are provided with the cash flows and the required rate of return, and we clear the net present value. Acceptance of the proposal depends on the net present value being zero or more.