Net Present Value Rule - Financial Management

To achieve the objective of shareholder wealth maximization, a set of appropriate decision rules must be specified. Earlier in this, we saw that the decision rule of setting marginal cost equal to marginal revenue (MC = MR) provides a framework for making many important resource allocation decisions. The MC = MR rule is best suited for situations when the costs and benefits occur at approximately the same time.

Many financial decisions, however, require that costs be incurred immediately but result in a stream of benefits over several future time periods. In these cases, the net present value rule provides appropriate guidance for decision makers. Indeed, the NPV rule is central to the practice of financial management. You will find this rule constantly applied throughout your study of finance.

The net present value (NPV) of an investment is equal to the present value of the expected future cash flows generated by the investment minus the initial outlay of cash, or

NPV = Present value of future cash flows minus Initial outlay

For example, in 2001, Airbus was considering whether to launch a new superjumbo jet project in competition with Boeing’s 747 family of jumbo jets. The development cost of the new plane was estimated to be $12 billion. The success of the project would hinge on the final costs of development, the cost of production, the price per plane, and the number of planes expected to be sold. Each of these factors is a key determinant of the annual net cash flows from the project. Airbus ultimately concluded that the expected cash flows were sufficient to justify the investment.

Boeing, in contrast, scrapped plans for an enlarged 747 model because they did not feel there would be sufficient demand for these monster planes. The net present value of an investment made by a firm represents the contribution of that investment to the value of the firm and, accordingly, to the wealth of shareholders. For example, if Dell Computer expects a new line of servers to have a positive net present value of $750 million, the value of Dell’s common stock can be expected to increase by $750 million at the time the investment is made, all other things being equal. The net present value concept provides a framework for evaluating future cash flows from an investment or a firm. Thus, the net present value concept can be viewed as the bridge between cash flows and the goal of shareholder wealth maximization.

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