Question

You have just sat through an informative lecture in your managerial accounting class about the net present value (NPV). However, one of your classmates leaned over to tell you that he is still unclear about this theory and would like for you to provide a summary of what this concept is all about and why it is so important. Explain to your classmate the key arguments for using NPV over other capital investment approaches and why it is the preferred method for making decisions about long-term investment opportunities.

Answer 1

NPV is the difference in the present value of cash inflows and the present value of cash outflows over a certain span of time.

The present value depends on the interval of time between the current time and when the cash flow will arise. It also depends on the discount rate. NPV takes into account the time value of money.

The formula for NPV is:

NPV= (Cash Inflows from Investment) - (Cash Outflows or Cost of Investment)

NPV is used to analyze an investment decision so that we can find out if the investment will add value to the company. If the investment has positive NPV, it will add value to the company. If the investment has a negative NPV, it will not be made by the company as will not add value to the company.

NPV method is important because it is based on the fact that cash that will be received in future is less worthy than cash in hand today. Stakeholders can see how much value a project is going to add to the company. It takes into account the cost of capital and the risk involved in projections about the future.

NPV is preferred over other methods because of a no. of factors like:-

-it considers time value of money.

-it takes care of cash flows till the end of the project

-it is easy to calculate even if we have different discounting rates for different years         

So based on the above details we can say that NPV is one the most important capital investment approaches to evaluate long term investment opportunities.