Would you expect the NPV based on net income to be higher or lower than the NPV calculated using cash flows?
Suppose an analyst makes a mistake and calculates the NPV for an investment project by discounting the project's contribution to net income each year rather than discounting its cash flow.
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The net present value or NPV of a project is the sum of the discounted value of cash flows for a time series that usually lasts for the project's lifetime.
The cash flow used while estimating NPV is the net cash flow. This is the gross cash inflow minus the gross cash outflow. If some accounting terminology is kept aside, the net cash inflow can be taken to be the same as the net income.
In the question, the analyst would not be wrong in calculating the NPV for the project by discounting the project's net income each year and adding the result. The NPV is used to determine if undertaking a project is appropriate or not for a required rate of return. Usually the outflow is higher than the inflow when the project starts giving a negative net cash flow. Later, as the project starts to make profits the inflows are larger than the outflows.
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