Reading: Net Present Value (NPV)

Once we understand the concept of net present values, it is rather straightforward to use it as a simple yet very powerful investment decision criterion, the so-called Net Present Value Rule, short NPV Rule:

• Only invest in projects that have a positive NPV. These projects increase the net worth of the investor.
• Avoid investing in projects that have a negative NPV, as these projects reduce the net worth of the investor.

Depending on the specific investment situation, the NPV rule can be fleshed out a bit more specifically:
 

• If there are multiple mutually non-exclusive projects, take all projects with a positive NPV.
   
• If multiple projects are mutually exclusive projects, take the one with the highest NPV.
   
• If all available projects have a negative NPV, do not invest in any of them. Instead, invest in the alternative asset or return the money to your investors.
   
• If all available projects have a negative NPV, but you have to take one, take the one with the smallest negative NPV (the one that destroys the least amount of value).
   
• If you have insufficient capital to fund all projects that have a positive NPV, choose those projects that have the highest combined NPV.

The following examples illustrate these applications of the NPV rule.