A project is therefore evaluated by subtracting the investment in capital (both productive assets and working capital) required today from the present value of the expected net cash flows (NCF) that the project will generate. This difference, called the net present value or NPV is then used to make the investment decision. The decision rule is "if the NPV is not negative, then invest else do not invest". The time horizon for the decision is an assumed finite value N years at the end of which all remaining assets are expected to be liquidated at a projected liquidation value. The liquidation value, net of taxes, becomes part of the NCF for year N.

Note that not all the CFO are available to the investor. Some of the cash flows generated may have to be set aside if additional working capital or capital expenditure is needed for operations in the following year. The remaining cash flows are called net cash flows or NCF.

To compute the present value of the NCF stream, the future value must be discounted back to the present using a discount rate, k that is appropriate for the perceived portfolio risk that the project is expected to add to the firm (recall that a firm is a portfolio of projects). The present value is then subtracted from the investment capital required; the difference is the NPV. In making the above computations all cash flows are assumed to be known with certainty. It is also normally assumed that the project NPV and the current firm's NPV are independent of each other. In this simple model the project is evaluated in isolation so correlation effects are not considered.

In such a simple decision process a single project is being evaluated as a "go" or "no go". Two kinds of errors are possible: a Type I error (bad investment) and a Type II error (under-investment, i.e., failure to take advantage of a profitable investment opportunity). Both error types reduce shareholder wealth.

A common mis-specification is to set k arbitrarily equal to the corporation's (current firm's) weighted average cost of capital (WACC). Remember that k is the REQUIRED return from the project and it must be based on the perceived portfolio risk of the project. If the risk is higher than that of the current firm, then the discount rate must be set higher than WACC. Using WACC may lead to a Type I error. If the risk is lower or the correlation is small (i.e. the addition of the project adds very little risk to the firm) WACC will grossly overstate the required returns and its use may lead to a Type II error.

The independence assumption can lead to Type I or Type II errors depending on the type of dependence. If the project adversely affects the current firm's NPV then the independence assumption may cause a Type I error. If the project has a positive impact on the current firm's NPV then the independence assumption may lead to a Type II error.