- Forecast the incremental cash flows the decision causes: the outlay, operating inflows, tax, working capital tied up and later released, and any salvage value.
- Pick a discount rate that matches the project's risk, often the firm's WACC when the project resembles the existing business.
- Discount each period's flow to today and add them up.
- Subtract the initial investment. Accept a positive result; among mutually exclusive options, take the largest.
The rule's logic comes straight from the time value of money. Discounting at the rate investors require turns every future amount into today's money, so whatever remains after paying for the investment is a surplus over what capital providers demand. CFA Institute's reading on capital investments treats NPV as its estimate of how much a project raises the firm's value and IRR as the project's rate of return, to be held against a hurdle rate. The two agree on whether a single conventional project clears the bar. They part company when projects differ in scale or timing, because IRR implicitly assumes interim cash can be reinvested at the IRR itself.
What stays out of the forecast
Sunk costs stay out, because they are spent whichever way the decision goes. Financing costs stay out of the cash flows as well, since the discount rate already charges for capital, and counting interest in both places charges for the same money twice. Sensitivity and scenario tables are not decoration: showing the result at several rates and several volume assumptions tells a board which input the decision really hangs on. NPV is the capital budgeting core of corporate finance and valuation, and a discounted cash flow valuation is the same calculation stretched over an entire company, using forecast cash flow rather than accounting profit.