7. Discussion

This section has introduced the most important criterion for capital budgeting decisions: The Net Present Value (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. 

  

Numerous examples have shown how to implement the net present value rule in different investment scenarios. We have also seen that it is fairly straightforward to compute the NPV of a project once we know its expected cash flows and the appropriate risk-adjusted rate of return. In fact, the preceding Example 10 is fairly representative for many real life investment decisions, as it involves an investment today, followed by a set of cash flows in future periods.

 

With the knowledge from this section, we should therefore be able to compute the NPV of virtually any stream of project cash flows!

 

Knowing what NPVs are and what information we need to compute them are important first steps towards sound investment decisions. In reality, of course, the main challenge usually is that cash flows and discount rates are not served on a silver platter:

  • To compute the NPV, we therefore first have to estimate the relevant expected future cash flows of an investment project.
  • And then we have to estimate the rate of return that investors could earn by investing in alternative projects with identical risk.

 

Estimating cash flows and discount rates can be complex tasks. They will be addressed in future modules. For now, we take cash flows and discount rates as given and keep working on our investment decision criteria.

 

Given its theoretical and practical relevance, the next step in our investigation is to take a closer look at some important foundations of the NPV rule. Then we turn to alternative decision criteria such as the project return and the payback rule and discuss their advantages and disadvantages compared to the NPV rule.