Question

This week we learn the Net Present Value (NPV) methodology for evaluating alternative approaches in the rational decision process. Fundamental to this methodology is forecasting future cash flows, both cash coming in and cash going out. The net cash flow forecast is "discounted" using an "appropriate" discount rate.

Reflect on the use of the NPV methodology -its benefits, its shortcomings.

• Why is the NPV tool so powerful?
• What are its shortcomings?
• What data do you need to conduct an analysis using NPV?
• What are other alternative methodologies presented in the chapter and how does NPV stack up against them?
• Have you used this methodology in your work or even in your personal decision when selecting among alternatives?
• How does your firm decide on the discount rate?  
• How careful should the decision-maker be in interpreting the results of the NPV analysis?

Answer 1

Before we go on, let’s get a basic idea of what net present value actually is. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a certain period of time. This is used mostly to assess the profitability of investments, in budgeting etc. As mentioned in the question- Fundamental to this methodology is forecasting future cash flows, both cash coming in and cash going out. The net cash flow forecast is "discounted" using an "appropriate" discount rate.

Let me answer all the questions one by one now.

- NPV is considered to be the gold standard of financial decision-making tools. NPV is the main tool used to make decio=sions about projects, purchases, mergers, and acquisitions. It helps us compare the costs and benefits in an elaborate yet simple manner. It answers the basic question in any business or financial decision- will I yield more than I put in?

- A few shortcomings of NPV are-

1- There are a few assumptions that need to be made. A very high or low assumption will not provide the appropriate results

2- It cannot compare two projects of different sizes

3- Selecting and accurately pegging the discount rate to use can be difficult.

4- It only takes cash flows into consideration, it does not include other important costs like opportunity costs that may have an impact.

- The formula for NPV is as follow

R_t= Net cash inflow-net cash outflow during time period t

i= Discount rate

- As the chapter the question speaks of is not available, I will not be able to answer this one.