Question

Discuss the pros and cons of net present value. explain in detail.

Answer 1

Net present value refers to present value of all the cash flows less the initial investment of the project, The Future cash flows are discounted by the rate of cost of capital or the required return of the project, if the project has Net present value of Zero then it shows that the project is giving more than required return or the cost of the project and if it is less than zero then it shows that the projecy would not worth the investment as it will not be able to give th minimum return.

Pros

1. Time Value : The Net present value considers the time value of the money as we know that the future of the money will not be the same, therefore, we discount the future cash flows by the appropriate rate which brings the cash flows in the present value.

2. Profit Maximisation : The Net present value helps to make the decision making and choose the projects that has highest net present value among different projects available as it would give the maximum return to the company and saving further cost of the company.

Cons

1. Discount rate or cost of capital : The Discount rate or the cost of capital of the firm is dependent on the lot of factors and it is difficult to predict it and it would not be the same in the future point of time due to economic, political and company specific factors or the reuired return of investors.

2.Different size projects: The Net present value is only effective when the projects of similar life is available, it fails to calculate the effective annual cost of the projects, Therefore, the results can be misleading.