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A corporate organization may incur a huge capital expenditure with the motive(s) of expanding operations and/or...

A corporate organization may incur a huge capital expenditure with the motive(s) of expanding operations and/or replacing a fixed asset. As a result of this, several appraisal techniques have been developed to help corporate organizations make the best investment decisions to increase the shareholders' wealth. However, among the various appraisal techniques the "Net Present Value (NPV) is considered as the king of capital budgeting." Critically examine this statement.

SUBJECT: MANAGERIAL FINANCE

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Expert Solution

Net Present Value (NPV) is a capital budgeting technique used for capital investment decisions. NPV is the difference between present value of all cash inflows and initial investment. It considers the cost of capital of the project. It is considered as the king of capital budgeting but this technique itself suffers from a lot of limitations.

NPV = Present value of all cash inflows - Initial investment

Criticism against Net Present Value (NPV)

  • NPV assumes the interest rate is constant : In the calculation of NPV, for the entire years, the same interest rate is taken. This is wrong because there will be changes in the interest rate over a period of time.
  • NPV does not consider hidden costs and other risks : NPV considers the initial investment as the cost of the project. Apart from this, there can be hidden costs and other risk in future. NPV ignores such costs.
  • When the projects with different lifetimes are compared, it will not provide reliable results : It is difficult to compare the projects with different lifetimes when NPV is used.
  • NPV is based on the estimated future cash flows. This estimated cash inflows may be different from the actual inflows. Then the results from NPV will not be reliable.

Since NPV suffers from these limitations, it cannot be treated as the best capital budgeting technique.

jeff jeffy answered 1 year ago
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