Net Present Value Method

The net present value method is the classic economic method of evaluating the investment proposals. It is discounted cash flow technique that explicitly recognizes the tine value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present values are found out. The following steps involved in the calculation that value:

• Cash flows of the investment project should be forecasted based on realistic assumptions.

• Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk.

• Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

• It should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if net present value is positive.

Project acceptance rule using net present value

It should be clear that the acceptance rule using that method is to accept the investment project if its value is positive and to reject it if the net present value is negative. Positive value contributes to the net wealth of the shareholders, which should result in the increased price of a firms share. The positive net present value will result only if the project generates cash inflows at a rate higher than the opportunity cost of capital. A project with zero value may be accepted. A zero value implies that project generates cash flow at a rate just equal to the opportunity cost of capital.

The net present value acceptance rules are:

• Accept the project it is positive

• Reject the project it is negative

• May accept the project when it is zero

The value can be used to select between mutually exclusive projects; the one with the higher value should be selected. Using the net present value method, projects would be ranked in order of that; that is, first rank will be given to the project with higher positive value and so on.

Importance of the Net Present Value

It is the true measure of investments profitability. It provides the most acceptable investment rule for the following reasons:

• Time value. It recognizes the time value of money-a $ received today is worth more than a $ received tomorrow.

• Measure of true profitability. It uses all cash flows occurring over the entire life of the project in calculating its worth. Hence, it is a measure of the projects true profitability. That method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations.

• Value additively. The discounting process facilitates measuring cash flows in terms of present values that is in terms of equivalent, current $. Therefore, the net present values of projects can be added.

• Shareholder value. That method is always consistent with the objective of the shareholder value maximization. This is the greatest virtue of the method.

Limitations of Net Present Value

The net present value method is a theoretically sound method. In practice, it may pose some computation problems.

• Cash flow estimation. That method is easy to use if forecasted cash flows are known. In practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty.

• Discount rate. It is also difficult in practice to precisely measure the discount rate.

• Mutually exclusive projects. Further, caution needs to be applied in using that method when alternative projects with unequal lives, or under funds constraint are evaluated. The net present value rule may not give unambiguous results in these situations.

• Ranking of projects. It should be noted that the ranking of investment projects as per that rule is not independent of the discount rates.