1. Introduction

The purpose of this module is to develop a metric that allows us to assess whether an investment decision makes financial sense. The basic idea behind that metric is fairly simple: An investment adds value if it generates more money than it costs. We therefore have to determine and compare the financial costs and benefits of an investment.

 

From the module Time Value of Money we know that most investment decisions involve a "time travel" with money: Usually, we invest today and harvest the fruits of the investment in the future. Because money has opportunity costs (we could invest it elsewhere and thereby earn interest), we need to make cash flows comparable over time by incorporating their amount, timing, and riskiness. The module Time Value of Money develops the necessary tools to make this comparison. In particular, it shows how to compute the present value and the future value of cash flows (or cash flow streams) that occur at different points in time. 

 

In this module, we build on the knowledge from the module Time Value of Money to develop a metric for the value added of an investment, the so-called Net Present Value (NPV):

  

Net Present Value = −Investment today + Present value of future cash flows

   

The section proceeds as follows:

  • It starts with a few simple examples that show how to get from the present value to the net present value.
  • It provides an interpretation of the NPV.
  • It shows additional examples to practice the computation and interpretation of the NPV.
  • It derives an investment decision criterion based on the NPV, the so-called NPV rule.
  • It provides a set of examples to practice the use of the NPV rule.
  • It concludes with a discussion of this rule and an outlook on the next steps ahead of us.