Please write a paragraph on your thoughts on the present value and the NPV capital budgeting...

Please write a paragraph on your thoughts on the present value and the NPV capital budgeting rule: Why PV is it so crucial in finance? Why is the NPV rule superior? Be as specific as possible, giving as many examples and interpretations as possible.

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The present value and the NPV in capital budgeting is used to estimate the present value of the future expected cash flows and is used to compare when the firm has to choose between various projects and also to decide if it has to undertake a project or not. The most critical estimation in NPV rule is the discount rate or the required rate of return. The PV is crucial in finance because only those projects should be undertaken which has a positive NPV. Otherwise, that project is not profitable for the level of risk it carries.

Situations in which there is only one alternative having a positive NPV, capital budgeting decisions would be made solely on the basis of the project's net present value. This is because no project is acceptable if it has a negative NPV. NPV can be driven higher either by higher positive cash-flows or lower discount rate. For eg. if a project has lower initial investment and very high returns (positive cash-flows), the NPV would be higher. Also, if the discount rate (required rate of return) is too less for the project, the NPV would be higher.

NPV holds an edge over other critetion like IRR, payback and discounted payback. Payback method doesn't even consider the time value of money. Here, for eg, a project if has a large postive cash flow only after 20 years, it is given the same weightage as the positive cash flow in year 1. Hence, this is a big flaw. In the discounted cash-flow method, even though the time valu of money is considered, the cash-flows beyond the discounted payback period are ignored. Thus if a project has a large positive or negative cash flows after the discounted payback period, it is directly ignored. IRR measures the internal return, however, here there can be conflict between NPV and IRR. IRR, cannot be obtained for all the projects and there can be a problem of multiple IRR. All these shortcomings are overcome in the NPV method hence it is the one which is considered and given the highest preferance

jeff jeffy answered 1 year ago

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