The Net Present Value (NPV) is a measure of an investment’s profitability. It can be either positive or negative. Positive NPVs are preferred because they point toward a profitable investment, while negative NPV investments are rejected as they show large losses.
NPV is important because it is the best rule to determine the profitability of an investment project. NPV is the most important investment rule for the following reasons.
Note − A positive NPV implies that the profitability of a firm in the present time and unit exceeds the NPV of another in the same time and unit.
NPV offers the true sense of money which considers that a certain amount of money is worth more in the present than in the future. This is important because other DCF methods do not consider this primary rule that determines the true value of an investment.
NPV considers all cash inflows and cash outflows to offer a clear picture of profitability. In fact, as all future cash flows are considered, it provides the anticipated income in the future. Although the future income is not guaranteed, NPV provides the most accurate tool to calculate the future income from an investment project.
Profitability is an important aim for any investment project and NPV offers a true picture of profitability which is why it is a so popular method of estimating future increases or decreases in wealth.
NPV and the discounting measures help to measure cash flows in present value terms or in terms of equivalent current rupees. That is each value is separate from the other and independent of one another. Therefore, we can write
NPV (A+B) = NPV (A) + NPV (B)
It is known as the Value Additivity Principle. It implies that if the individual NPVs of projects are known, we can find the NPV of the firm by adding all the NPVs of individual projects. It is also implied that adding the NPVs of each project will give the total NPV of a firm. Value additivity is an important principle because each project can be measured on its own independent of the others.
NPV offers the idea of shareholders’ wealth maximization which is the biggest merit of the calculation. Knowing the shareholders’ wealth is important because they are the ones who invest in the project.
Being able to increase the shareholders’ wealth is the aim of NPV and using NPV, we can pre-assume it. That is why NPV is so important a measure accepted and applied by economists and finance managers.