Why NPV Net Present Value is best method of Evaluating Projects
An investment project is attractive and should be pursued so long as the discounted net present value of cash inflows is greater than the discounted net present value of the investment requirement, or net cash outlay. Because the attractiveness of individual projects increases with the magnitude of this difference, high NPV projects are inherently more appealing and preferred to low NPV projects. Any investment project that is incapable of generating sufficient cash inflows to cover necessary cash outlays, when both are expressed on a present value basis, should not be undertaken. In the case of a project with a NPV = 0, project acceptance would neither increase nor decrease the value of the firm. Management would be indifferent to pursuing such a project. NPV analysis represents a practical application of the marginal concept, where the marginal revenues and marginal costs of investment projects are considered on a present value basis. Use of the NPV technique in the evaluation of alternative investment projects allows managers to apply the principles of marginal analysis in a simple and clear manner. The widespread practical use of the NPV technique also lends support to the view of value maximization as the prime objective pursued by managers in the capital budgeting process.
Just as acceptance of NPV > 0 projects will enhance the value of the firm, so too will acceptance of projects where the PI > 1, and the IRR > k. Conversely, acceptance of projects where NPV < 0, PI < 1, or IRR < k would be unwise and reduce the value of the firm. Because each of these project evaluation techniques share a common focus on the present value of net cash inflows and outflows, they display a high degree of consistency in terms of the project accept/reject decision.