Question

Why NPV considered to be a superior method of evaluating the cash flows from a project and what is the NPV criterion decision rule? Explain.

Answer 1

The NPV of an investment is found out by discounting the cash inflows and outflows associated with the investment and it is obtained as:

NPV = PV of cash inflows-PV of cash outflows.

The decision rule for NPV is:

NPV>1; Accept the project

NPV<1; Reject the project

NPV = 0; be indifferent, that is, can accept or reject the project.

The reasoning for the above decision rule is explained below:

1] When a project has positive NPV, it means that:

*the contracted return to the debt holders and preference shareholders is paid.

*the required return to the common stockholders is paid,

*the principal amount of debt, the paid up preferred capital and the paid up common capital are repaid, and

*something more is left, which would go to the common stockholders' as they have the sole right to the surplus funds.

When the last event happens, it means that the shareholders' wealth is enhanced, as they get something more than their required return and their contributed capital.

2] When a project has negative NPV, there would be no addition to shareholders' wealth. Instead, the shareholders' wealth would be reduced.The project should then be rejected.

3] When the NPV is 0, the shareholders' wealth before and after implementation of the project remains the same.

This then is the superiority of the NPV rule--that it gives the direct addition to shareholders' wealth if an investment is made.

Besides, NPV also helps to rank projects, with the ranking done in descending order of NPV.

In contrast, the IRR gives only the rate of return of the investment and the profitability index is a ratio that gives the return per $ invested in PV terms. Both the metrics do not tell how much the addition to shareholders' wealth is. The IRR, further, has drawbacks like, multiple rates, conflicting ranking with NPV and so on.

For the foregoing reasons, the NPV is superior.