Question

When the amount invested differs substantially across projects, NPV is of limited value for comparison purposes. You have evaluated three projects of substantially different investment amounts using the net present value (NPV) method. How would you decide which one of the projects to select?

Answer 1

Net Present value (NPV) Method

It is common we find difficulty to selected the best Investment proposal/ project from the options available. Net present value (NPV) method is the best method to evaluate each and every options available in order find the best one.

Net present value method is a popular capital budgeting technique that takes into account the time value of money. It uses net present value of the investment project as the base to accept or reject a proposed investment in projects like purchase of new equipment, purchase of inventory, expansion or addition of existing plant assets and the installation of new plants etc.

First, I would explain what is net present value and then how it is used to analyse investment projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the present value of cash outflows that occur as a result of undertaking an investment project. It may be positive, zero or negative. These three possibilities of net present value are briefly explained below:

a) Positive NPV: If present value of cash inflows is greater than the present value of the cash outflows, the net present value is said to be positive and the investment proposal is considered to be acceptable.

b) Zero NPV: If present value of cash inflow is equal to present value of cash outflow, the net present value is said to be zero and the investment proposal is considered to be acceptable.

c) Negative NPV: If present value of cash inflow is less than present value of cash outflow, the net present value is said to be negative and the investment proposal is rejected.

Advantages and Disadvantages of the NPV method

1) The advantage of NPV among other project valuation techniques is that it uses a discounted cash flows approach. Thus, it helps to estimate the additional shareholders’ value taking into account the time value of money concept.

Despite the obvious advantages of the NPV method, some disadvantages should be taken into account during project valuation.

1) Sensitivity to discount rate. One of the basic assumptions is that all of the project’s cash flows are reinvested at the discount rate. Actually, interest rates fluctuate over time, depending on the changes in economic conditions and inflation fears. Moreover, these fluctuations may be significant, especially in a long-term outlook. So, the actual change in the shareholders’ value can be quite different from the initial estimation.

2) Cash flows beyond the lifetime of the project. Some projects can provide cash flows after the initial expected lifetime. These cash flows can provide additional shareholder value to the initial estimation, but they are ignored by the NPV method.

3) Real options. During the lifetime of the project, management can undertake some actions influencing its timing or scale in response to changes in market conditions. These actions may change both the time of occurrence and the amount of cash flows, which, in turn, will lead to the change in shareholder value provided by the project. Traditional discounted cash flow analysis does not take such changes into account.

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