Question

List the assumptions of the NPV model. Are these assumptions valid when a company is considering extending its credit period from 30 to 90 days, if all its competitors retain a 30-day credit period?

Answer 1

NET PRESENT VALUE(NPV) is the difference between the present value of the cash in-flows and present value of the cash outflows over a period of time. A positive NPV indicates that we should go forward with the project while a Negative NPV indicates that we should not go forward with the project.

Assumptions: The NPV model is based on the two assumptions which are as follows:

1.The cash generated by a project is immediately re-invested to generate a return at a rate which is the discount rate of the project used to do the Present Value Analysis.

2.The inflow and outflow of cash occur at the end of each period.(Other than the initial investment which occurs at the beginning of the year)

When a company is considering extending its credit period from 30 to 90 days, when all its competitors retain a 30 day credit period, the NPV assumptions are still valid.Because still the inflow and outflow will occur at the end of each period(inflow will occur at the end of 90 days instead of 30 days) and also it will be assumed that the cash generated will be immediately reinvested at the discount rate of the project.