What is Net Present Value Rule?
The net present value rule is the idea that investors and managers should only engage in deals, projects or transactions that have positive net present value (NPV).
How Does Net Present Value Rule Work?
Using the NPV formula, the net present value rule decides if an acquisition or project is worth it based on the following criteria:
If NPV < 0, the project/acquisition will lose the company money and therefore may not be considered.
If NPV = 0, the project/acquisition will neither increase nor decrease value of the company and non-monetary benefits may instead be considered before a decision is made.
If NPV > 0, the project/acquisition should be accepted as it wil increase profit and therefore value of the company.
Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company ABC's projections for the next 10 years. It discounts those cash flow projections back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of buying Company ABC.
Cost to purchase Company ABC today: $1,000,000
Projected total of cash inflows for the next 10 years: $2,000,000
Net Present Value (NPV) = $1,000,000
Using the net present value rule, Company XYZ should purchase Company ABC because the net present value of this project is Positive. It will generate a cash benefit that will exceed the cost of the acquisition and will therefore add value to the company.
Why Does Net Present Value Rule Matter?
The net present value rule helps management use the NPV calculation to decide if a company acquisition or project will add value to a company or not. The rule can be an effective way to cut through the anxiety of decision-making.
Deals often have a myriad of tangible and intangible considerations, but the question of whether the cash flows are sufficient to 'pay for' the initial investment is often more black and white. Hence, the net present value rule is often at the top of the list when boards and investors are deciding whether to make an acquisition or start a project.