Define net present value, and explain how it is calculated.Solut.pdf

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Net present value (NPV) is a capital budgeting technique used to evaluate capital projects. NPV is calculated by discounting the future cash inflows of a project by the cost of capital to get the present value of cash flows, then subtracting the initial investment amount. If NPV is positive, the project generates higher returns than the investment and is accepted; if NPV is negative, returns are lower than investment and the project is rejected. NPV is calculated by taking the sum of discounted future cash flows and subtracting the initial investment amount.

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Define net present value, and explain how it is calculated.
Solution
Net present value is a Capital Budgeting technique used to evaluate the acceptability of a Capital
project. In this method the future cash inflows of a project are discounted by the cost of capital to
get the present value of the cash generations from the project. Difference of this PV of cash
inflows and the intial investment amount of the project is the Net Present Value or NPV of the
project. If the NPV is positive then the projcet has generated more return to the investors than the
invested amount and the opposite is true when NPV is negative. A project is accepted when its
NPV is positive . It is a very simple and effective method of Capitalinvestment evaluation.
For example the Invetsment in a project is I , amd it generates cash flows c1, c2 ,c3 ......cn in n
years and the cost of capital is r.
Then NPV of the project will be
c1/(1+r) + c2/(1+r)^2+c3/(1+r)^3 ......cn/(1+r)^n - I ( assuming Invetment is done in the initial
year , so no discounting required )
When this value is >0 , the project is accepted and when this is <0 , then the project is rejected.

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