Is there a case where NPV might not be the best methodology to evaluate new investments?...

Is there a case where NPV might not be the best methodology to evaluate new investments? If so, how could the problem be overcome?

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Expert Solution

Net present value is a method of evaluation of capital budgeting which considers the time value of money and discounts the cash inflows to their present value based on cost of capital. The initial investment is deducted from the present value of cash inflows. If Net present value is positive project is accepted else the project is rejected.

However in certain cases net present value is not the best methodology to evaluate the investment. Below are the 2 situations given and how to overcome them

1. In case of projects having unequal lives both projects may have positive net present value. Just calculating NPV may not help in deciding which project should be chosen for investment. In order to decide which project is giving more benefit Profitablity index should be calculated. Profitablity index is calculated by divided present value of cash inflows with initial investment. It expresses present value of cash inflows as a relative percentage of cash outflows which is more meaningful measure compared to NPV.

2. During uncertain times recovery of initial investment is of prime importance. Net present value does not give any measure of recovery on investment. A project might have positive NPV due to cash inflows in its later years. Hence NPV may not help in initial investment recovery. Payback method can be used to overcome this drawback since in payback cost of investment recovery is calculated. The sooner the investment recovered it is good for the firm. To consider time value of money, discounted payback method can be used.

ekkarill92 answered 1 year ago

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