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Two comments about our example are in order. First and foremost, it is not the rather mechanical process of discounting the cash flows that is important. Once we have the cash flows and the appropriate discount rate, the required calculations are fairly straightforward. The task of coming up with the cash flows and the discount rate in the first place is much more challenging. We will have much more to say about this in the next several chapters. For the remainder of this chapter, we take it as a given that we have estimates of the cash revenues and costs and, where needed, an appropriate discount rate.

The second thing to keep in mind about our example is that the -$2,422 NPV is an estimate. Like any estimate, it can be high or low. The only way to find out the true NPV would be to place the investment up for sale and see what we could get for it. We generally won't be doing this, so it is important that our estimates be reliable. Once again, we will have more to say about this later. For the rest of this chapter, we will assume the estimates are accurate.

Using the NPV Rule

Suppose we are asked to decide whether or not a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the five-year life of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year. It will cost about $10,000 to begin production. We use a 10 percent discount rate to evaluate new products. What should we do here?

Given the cash flows and discount rate, we can calculate the total value of the product by discounting the cash flows back to the present:

Present value = ($2,000/1.1) + (2,000/1.12) + 4,000/1.13) + (4,000/1.14) + (5,000/1.15) = $1,818 + 1,653 + 3,005 + 2,732 + 3,105 = $12,313

The present value of the expected cash flows is $12,313, but the cost of getting those cash flows is only $10,000, so the NPV is $12,313 - 10,000 = $2,313. This is positive; so, based on the net present value rule, we should take on the project.

As we have seen in this section, estimating NPV is one way of assessing the profitability of a proposed investment. It is certainly not the only way profitability is assessed, and we now turn to some alternatives. As we will see, when compared to NPV, each of the alternative ways of assessing profitability that we will examine is flawed in some key way; so NPV is the preferred approach in principle, if not always in practice.

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