Question

What is the NPV? What are some advantages and disadvantages? How is it computed? What is the decision rule criteria?

Answer 1

NPV, is the difference between the present value of cash inflows and the present value of cash outflows. It is used to determine the feasibility of an investment project and determine its profitability. It is used in making capital budgeting decisions.

Advantages:

• It takes into account the time value of money.
• In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.
• It prioritizes the profitability of projects and risks associated with projects.

Disadvantages :

• It requires making guesses about the future cash flow and the cost of capital.
• it might not yield accurate results, when comparing two projects with unequal life.
• The NPV method is a bit complicated to use.

The NPV is computed as :

CF0 = $10,000

CF1 = $2000

CF2= $3000

CF3= $4000

At discount rate of 5%, the NPV will be :

($10,000) + $2000/1.05 + $3000/1.05^2 + $4,000/1.05^3

= ($1918.7993)

The decision rule of NPV states that:

If the NPV is positive and > 1, the projects with the highest NPV should be selected and negative NPV projects should be rejected as these projects lead to destruction opf wealth.