Net Present Value

Net Present Value (NPV) is one of the approaches used in capital budgeting. The NPV approach analyses projects based on the capital invested and the cash inflows generated. In this case, the cash flows are discounted based on the expected rate of return. This implies that the discounting factor takes into consideration the time value of money. When projects undergo evaluation, the projects that provide positive NPV are considered for implementation. In addition, projects with the highest NPV are accepted while those with negative NPV are rejected. Nevertheless, when the NPV is equal to zero, decision makers become indifferent about the projects. As a result, it is one of the most rigorous, verifiable and reliable means of financial decisions (Ross, 2008).

An example to demonstrate the use of NPV can be reflected by a company wishing to make decision on two projects costing $70,000 and $ 50000 when the required rate of return is 15%. If the inflows expected from the two projects are $40000 and $20000 respectively over the next three years, to obtain the NPV of each project, one needs to discount the cash flows to the present value using the required rate of return of 15%. As a result, the present value of each project would be $91327 and $45663. Having obtained the present value, we derive the NPV by subtracting the initial capital from the present value. This will yield two different NPVs of $21327 and $4337. Based on this finding, it would be essential for the company to select the first project with positive NPV.

Some of the benefits of the NPV are the fact that it is easy to calculate and is one of the most reliable investment appraisal techniques. Similarly, it takes into consideration the time value of money. On the other hand, the calculation of NPV is based on predicted value of cash flows, which may not be actual. Therefore, it may give unrealistic estimates.