Net Present Value

To maximize firms’ profits, the firms consider adding new projects sometimes. The new projects could increase of decrease firm’s profits. When the firms start their new project they need operational cost, initial cost, and etc. Thus, the firms usually spend lots of money in the beginning of the year. If the firms do not earn less than what they invested, they should not start their new projects. Thus, the firms need to assess the impact of the new projects. To calculate the impact of new projects, we need to use net present value function: net cash flows divided by the discount rates. To calculate net cash flow, we could simply subtract cash outflows, which are costs, from cash inflows, which are revenues. When we divide discount rate, the important factor is what interest rate we should use. Risk managers decide the rate of return as if they could earned from similar projects. Thus, if a firm adds a risky new project, its discount rate would be higher than the lower risk project. If the firm’s net present value is greater than zero, the firm can take the new project. If it is less than zero, the firm should not take it. If it is equal to zero, the firm may or may not take it. However, I do not recommend to add a new project if net present value is zero. The reason is that net present value equals zero means they are in borderline, so they could lose or earn profits. In addition, we do not know probability to lose or earn from that new project. Thus, I would not recommend investing if net present value equals zero. I have a concern that when we calculate net present value, the net cash flows and discount rates are not guaranteed factors. Those are only assumed by risk managers. Sometimes, a new project ends up with negative profits in the real field even though their net present value is positive. Therefore, if net present value is not high enough, I do not recommend taking the new project.

http://en.wikipedia.org/wiki/Net_present_value