Understanding financial management is one of the important things when we want to make a financial decision. We can use our understanding depends on the needs. We can place ourselves as the owner of the company or as an investor and creditor. As an investor we can see the financial management to make an investment decision, to buy or not to buy the stocks or even to sell the stocks. As a creditor we can use our understanding to make a financial decision on giving a lending to other company, do they credible to get our lending or not, or calculating the risk if we lend to that company. And as the owner of business we can use our understanding to make a decision weather running a business or not running it.
One of method that we can use is the net present value method. The net present value (NPV) method can be a very good way to analyze the profitability of an investment in a company, or a new project within a company. With this concept we can analyze an investment decision and give a clear projection if the investment will give a good benefit to the company or not. And also it can be used for calculation projected future cash inflows.
Money today is worth more than money tomorrow. Money tomorrow is worth more than money in the future.
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
When NPV is used to make accept–reject decisions, the decision criteria are as follows:
- If the NPV is greater than $0, accept the project.
- If the NPV is less than $0, reject the project.
If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners.
So, if the net present value is positive, then it’s a good decision to do that business, means that the present value earnings is bigger than present value of payments. But in the opposite if the net present value is negative then it’s a bad idea to do that business, means that the present value of earnings is less than the present value of payments.
Gitman, Lawrence. Principle of Managerial Finance Tenth Edition.