Method Four: Financial Models - Net Present Value

This approach is probably the most popular for financial decision making in project selection. NPV gives the dollar change projects expected in the firm's stock value if a project is undertaken. As a result, a positive NPV indicates that the firm will make money (the value of the company will rise) in undertaking the project.

The simplified formula for NPV is:

Where:

F_t = the net cash flow for period t

K = the required rate of return

I = initial cash investment (cash outlay at time 0)

P_t = inflation rate during period t

For example, consider a situation in which a firm has the opportunity to invest in a new project. The initial investment cost is $200,000 and the projected net cash inflow per year for the 10-year life of the product is $60,000. Assuming the firm has a required rate of return (hurdle rate) of 15% and anticipated inflation rate is pegged at 3%, we can calculate the NPV for the project as

Clearly, there would be strong incentive to invest in this project. It has a positive NPV, suggesting that the anticipated revenue generated from the project would more than cover the initial cash outlay required to fund it.