Net Present Value Method

Net Present Value Method

• It is one of the methods of Capital Budgeting comes under the discounted
cash flow methods
• It recognizes the impact of time value of money
• It is considered as the best method of evaluating the capital investment
proposal which is widely used in practice
• This method is based on the economic reasoning of discounting future
cash flows to make them comparable
• The emphasis is that money received today is more valuable than
equivalent amount of money received next year or the year after(because
money received today can be invested to earn some interest)
Net Present Value Method(contd)
-Under this method the cash flow will be discounted at a particular
discount rate
Cash inflow means (returns) before depreciation (but) after tax
-It is calculated by discounting all future flows to the present and
subtracting the present value of all out flows from the present value of
all inflows
-It can be written as NPV= Total present value of the cash inflow minus
Original investment
-Symbolically, NPV= Sum of Rt/(1+r)t - C where
Net Present Value Method (contd)
t=time period from 0 to n years
Rt=cash flow in period t
C=initial investment or cash outflow
r=discount rate(cost of capital)
Interpretation & Decision rule of the NPV is
1. If the NPV is positive it indicates that project adds more to the revenue than
it adds to the cost. Therefore accept the project
2. If the NPV is negative it indicates that project adds less to the revenue than
it adds to the cost. Therefore accept the project
3. If the NPV is zero it is a situation of indifference towards the project
Merits and Demerits of the Net Present Value
Method
Merits: 1.It recognizes the time value of money and discounts future cash values
to present value by taking an appropriate discount rate
2.It is a comprahensive tool because it considers the cash inflow of the entire
project, period of time and risk involved in the project
3.The tool quantifies the gain or loss from each of the project and gives the value
of the total profit to maximise the welfare of the owners
Demerits: 1. The main limitation is the determination of Rate of Return
(if higher rate of return is assumed it can show false negative net present value
and if a lower rate of return is taken it will show the false profitability of the
project)
2. It suffers from some operational problems like:
Merits and Demerits of the Net Present Value
Method(contd)
a) Determining an appropriate discount rate
b) Difficult calculations which can not be easily applied
c) Comparison of different projects having two different time periods or the risks involved in the project
3. The method is based on the multiple assumptions like:
a) cash generated by a project is immediately reinvested to
generate a return at a rate that is equal to the discount rate
used in the present value analysis
b) the inflow and outflow of cash other than initial investment occur at
the end of each period
c) there might be a lot of expenditure that will come to surface only when the
project actually takes off and the inflow may not always be as expected which may result
in wrong decision making.
Merits and Demerits of the Net Present Value
Method(contd)
• Conclusion: Inspite of all these drawbacks due to the technological advancements, the NPV method is
widely used by the analysts in assisting the management in their investment decisions.
The various methods of capital budgeting are profit oriented and miss several other considerations like:
a) Urgency of the project
b) Type of investment
c) Non profit considerations like prestige and image of the company, employee morale etc.,
d) Government policies and legislations like MRTP Act, FEMA, CCI Act etc.,
e) overall profitability of the organization
f) judiciously combining small and large projects,
which really matters to the businessmen.
The available methods are only guidelines and the selection of an investment proposal depends upon
the value judgment of the managers and the top boss.