Question

Explain why the net present value (NPV) generally leads to good investment decisions.        

Answer 1

Answer:

Introduction of NPV

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

Net present value is used in Capital budgeting to analyze the profitability of a project or investment. It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.

Advantages of using NPV

#1 – Time Value of Money

The primary advantage of using NPV is that it considers the concept of the time value of money i.e a dollar today is worth more than a dollar tomorrow owing to its earning capacity. The computation under NPV takes into account the discounted net cash flows of an investment in order to determine its viability. To understand how present value figures are important in capital budgeting, let us consider the following example –

Example

A company is looking to invest $100,000 in a project. The required rate of return is 10%. The following are the projected earnings of project A and project B.

• Project A – Y1 – $10,000, Y2 – $12,000, Y3 – $20,000, Y4 – $42,000, Y5 – $55,000 and Y6 – $90,000.
• Project B– Y1 – $15,000, Y2 – $27,500, Y3 – $40,000, Y4 – $40,000, Y5 – $45,000 and Y6 – $50,000.

If the time value of money is not considered, the profitability of the projects would be the difference between the total inflows and total outflows, as depicted in the table below –

Judging by these figures, Project A would be considered profitable with a net inflow of $129,000.

In the same example, however, if the time value of money was considered,

*Discounted at 10%

It is evident that Project B is more profitable in terms of the present value of future cash flows with a discounted net inflow of $49,855. Therefore, it is essential that the time value of money is considered, to determine, more accurately, the ideal investment for a company.

#2 – Decision-Making

NPV method enables the decision-making process for companies. Not only does it help evaluate projects of the same size, but it also helps in identifying whether a particular investment is profit-making or loss-making

Example

Let us consider the following example –

A company is interested in investing $7500 in a particular venture. The required rate of return is 10%. The following are the projected inflows of the venture –

Y1 – $(500), Y2 – $800, Y3 – $2300, Y4 – $2500, Y5 – $3000.

NPV of the project (as computed using the formula) = $(1995.9)

In the given case, the present value of cash outflow is higher than the present value of cash inflows. Therefore, it is not a viable investment option. Another advantage of NPV is that it helps to maximize the earnings of the entity by investing in ventures which provide the maximum returns.

Why net present value leads to better investment decisions:-

The net present value The basis for the net present value method is the assumption that a hundred Euros today is worth more than a hundred Euros will be worth tomorrow, because the Euros today can be invested to start earning interest immediately. An Advantage is, that present values are all measured in today’s dollars, you can add them up

The payback rule: Some companies require that the initial outlay on any project should be recoverable within a specified period. This means, at the beginning of the investment the managers make the decision in which period they will get their invested money back. They set a cut-off date.

The IRR rule

  The IRR rule states that if the internal rate of return on a project or investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued

Conclusion

The Net Present Value method is the one investors are most able to trust.The net present value rule tells us which projects we have to accept, and which we should reject. However, the payback rule ignores all cash flows after the cut-off date, and will tend to accept many poor short-term projects and reject many good long-term ones. Applying the internal rate of return method, we have to find out the NPV. It is not possible to make an exact investement decision because it states the same IRR, even if you lose a lot of money

So  net present value (NPV) generally leads to good investment decisions.