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What is Net Present Value (NPV) and what are the pros and cons of using NPV method in Capital Budgeting?
Net Present Value (NPV) is the value of a fund that would mature in the future. The NPV method is used for financial analysis and to determine the feasibility of a project. It is the value of future cash inflows and outflows in relation to initial investments made by an individual or a firm.
What is NPV?
An organization needs to take very conscious and wise decisions about growth and expansion. In many cases, huge amounts of funds are involved. So, the organizations need to do capital budgeting. NPV is a good option to calculate the capital budgets to find the most profitable option.
NPV is a great tool for capital budgeting and it is calculated by finding the difference between net cash inflows and net cash outflows over a period of time in the present. NPV is the net off the present values of cash inflows and outflows which are discounted at a given rate.
The formula for calculating NPV is,
NPV = Rt/(1 + i) t
Where
Rt = Net cash flow
i = Interest
t = Time of cash flow
It could be seen in the formula that to get the present value the cash flows must be discounted at a given rate. The rate is calculated comparing with the comparable investments risks, or borrowing costs. NPV is based on the concept of the time value of money. It provides information on whether taking up a project is profitable or not.
After discounting the cash flows over different time periods, the initial investment is subtracted from it. If the value is positive, then the project is selected and if NPV is negative the project is discarded. In case NPV is zero no action is taken.
Advantages
NPV takes care of the time value of money. If the cash inflows occur in the present than in the future, the project that has inflows later will be rejected. This is in sync with time value because the equal amount of money earned earlier is of more value than the money earned on a later date.
NPV takes all aspects of investment into consideration, such as risk, inflows, outflows, and time. Therefore, it is an all-in-one method.
Apart from showing all the details of the investment, NPV provides the gains from a particular project too. So, one can understand the exact effect of investments and cash inflows and outflows of a project more easily.
Limitations
Choosing the right discount rate is important in NPV. A higher rate will show a negative NPV while a lower rate will show a positive one. So, determining the rate is tough and challenging.
Two different projects cannot be compared under one umbrella in the case of NPV. Given the date, time and risk, one must calculate different NPVs for two projects.
Multiple assumptions have to be taken while considering the NPV of a project and sometimes some assumptions may be wrong. This will give a wrong result which will further disbalance the calculation procedure.
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