Question

Present one of the methods used to analyze potential investments, how the method is calculated, and the advantages and disadvantages in using the specified method.

Answer 1

Net present value: The NPV method is one of the most important methods used to analyse potential investments by way of determining the present value of the project's projected future income. In calculation of NPV, the present value of the project's cost is subtracted from the present value of future income. A positive net present value indicates that the project should be accepted. Organisations while making the comparison between two or more projects tend to favor the one with the higher net present value

Advantage of Net present value

1. NPV gives privilege to the time value of money.

2. In computing NPV, both before cash flow and after cash flow over the life span of the project are considered.

3. Profitability and risk of the projects are given high importance

4. NPV helps in maximizing the firm's value.

5. The NPV method provide details on whether an investment will create value for the company or the investor, and the value in terms of dollars

6. Net present value method has the ability to compare projects

Disadvantages Of Net Present Value (NPV)

1. NPV is difficult to use as the calculations are complex.

2. NPV cannot provide proper accurate decision in case the amount of investment of mutually exclusive projects is not equal.

3. It is difficult to compute the appropriate discount rate.

4. NPV may not provide correct decision when the projects are of unequal life.

5. NPV requires some assumptions about the cost of capital of the firm. Assuming a cost of capital that is too low may lead in making suboptimal investments and assuming a cost of capital that is too high may lead in forgoing too many good investments