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It makes sense that project C should have the highest NPV, since its cash outflows are deferred
relative to the other projects and its cash inflows are early. Project B, alternatively, has all costs up
front, but its cash inflows are deferred.
Suppose a project has positive NPV, but the NPV is small, say, only a few hundred dollars. The
firm should nevertheless undertake that project if there are no alternative projects with higher NPVs.
The reason is that a firm‟s value is increased every time it undertakes a positive-NPV project. The
firm‟s value increases by the amount of the project NPV. A small NPV, as long as it is positive, is net
of all input costs and financing costs. So, even if the NPV is low, the project covers all its costs and
provides additional returns. If accepting the small-NPV project does not preclude the undertaking of a
higher-NPV project, then it is the best thing to do. A firm that rejects a positive-NPV project is
rejecting wealth.
Of course, this does not mean a firm should jump headlong into any project that at the moment
appears likely to provide positive NPV. Future potential projects should be considered as well, and
they should be evaluated as potential alternatives. The projects, current or future, that have the highest
NPVs should be the projects accepted. For maximum wealth-creation efficiency, the firm‟s managerial
resources should be committed toward undertaking maximum-NPV projects.
Outsourcing and the Build/Buy Decision
Firms are often faced with the question of whether it is better to undertake a particular function
internally or, alternatively, outsource the function to an external entity. For example, should an online
retailer undertake the fulfillment process of packaging and shipping itself, or should it subcontract the
job to an outside company? Similarly, firms are often faced with the dilemma of whether it is better to
build enterprise software or other productive assets in-house, or alternatively buy such assets readymade
from outside vendors. While the issues of core competencies, strategic fit, and managerial
capacity must also be considered when making such decisions, an NPV analysis can help organize the
issues and can help point the firm toward the optimal path. The alternative with the highest NPV
creates the most value for the company.
The Discount Rate
At what rate should cash flows be discounted to compute net present values? In most cases, the
appropriate rate is the firm‟s cost of funds for the project. That is, if the firm secures financing for the
project by borrowing from a bank, the after-tax interest rate should be used to discount cash flows. If
the firm obtains funds by selling stock, then an equity financing rate should be applied. If the
financing combines debt and equity, then the appropriate discount rate would be an average of the
debt rate and the equity rate.
Cost of Debt Financing