This essay will discuss the net present value (NPV), payback period (PBP) and internal rate of return (IRR) approaches for a project evaluation. It is often said that NPV is the best approach investment appraisal, which I why I will compare the strengths and weaknesses of NPV as well as the two others to se if the statement is actually true. Introduction To start of, the essay will attempt to explain the theoretical rationale of the net present value approach to investment appraisal as well as its strengths and weaknesses.
From there, introduce the payback period method and then internal rate of return approach, as well as to consider their strengths and weaknesses. After outlining and explaining the three different approaches, it will finish up with comparing the different three and in a conclusion. NPV Net present value or NPV is an approach used to determine the value of an investment today (present) compared to the value of the investment in the future after taking the inflation and return into account.
In simpler words, it compares the value of 1 pound today with the same pound in the future. Net present value is used in capital budgeting to analyze the profitability of an investment. It is usually calculated using tables and spreadsheets such as Microsoft Excel, but the main formula used to calculate net present value looks like this: Where C0 = Cash outflow at time t=0 Ct = Cash inflow at time t r = The discount rate As Ross (2013) states in his book, a project should be accepted if the NPV is greater than zero and rejected if it is less than zero.
This is known as the NPV rule. However, if the NPV is equal to zero, the manager of the company has to decide whether to accept or reject depending on several factors, such as there might be a better investment to be made elsewhere that might produce higher revenue. It will be a question of opportunity cost. The whole point of the rule is that if a firm accepts an investment with positive net present value, it will benefit the shareholders, as the value of the firm will increase (considering no other circumstances) by the amount of the NPV.
This is called additivity, which means that the value of the firm is simply the value of the different divisions, projects, or other entities within the firm. Alexander (2000) states that any financial asset with an NPV greater than zero is referred to as underpriced, while any financial asset with an NPV less than zero is said to be overprices. A firm or company must always consider is the concept of ‘time value of money’ (TVM). TMV means that if ?
1 is invested today, say for instance in a bank or a fund, with an interest rate of 5 per cent per annum, in one year it will be ? 1. 05 because the bank compensates the investors for borrowing their money. The same would be if you reverse the equation. ?1 in a year with the same interest rate of 5 per cent equals ? 0. 9524 today (Weetman, 2010). The reason for discounting future cash flows according to Marney (2011) are because of three factors; inflation, risk and time impatience.
In all countries there is some level of inflation that needs to be accounted for. It can lead to both higher and lower purchasing power of money. Risk is very hard du make accurate predictions for in the far future, and after the credit crunch of 2007-2008, very few dare to make them on variables like inflation and interest rates. Lastly is the factor of time impatience. Since mankind is born with some level of greed, people prefer money now rather than later. This can easily be reflected by the use of credit cards and loans in general.
And as long as people want to lend and borrow, there is money to be made for lenders, as incentives are required with the gratification in the form of interest. The main advantage with the net present value technique according to Ross (2013) is that is uses cash flows, it includes all the cash flows of the project and that it rightly discounts the cash flows properly. The positive aspect of it using cash flows is that it determines when the project will earn its incomes, how soon they will come as well as how sizable they are going to be.
What is meant when he states that it uses all the cash flows is that it acknowledges every single cash flow, regardless of the date or the size. The advantage for the shareholders of the firm is that it shows how much they can expect to get back from an investment as it takes into account the riskiness of the project and doesn’t ignore the time value of money. However, the NPV approach those have some disadvantages as well. The main disadvantage to the net present value approach is that it is sensitive to discount rates.
The computations of NPV are a summary of multiple discounted cash flows that are converted into present value terms for the same point in time. This could affect the result both positively and negatively, and as said earlier, it is almost impossible to predict what the future brings. Let’s use the example given in the article “Uses, abuses and alternatives to NPV” by Ross (1995). If the current interest rate leads to a negative NPV, but in the future the interest rate decreases and leads to a positive NPV.
The management or analyzers may miss out on a good investment opportunity if they sell the project early because with the current interest rate it is considered not profitable. Another example, let’s call it project a, could be if we were trying to value an investment that could cost your firm ? 10,000 up front today and was expected to pay you back ? 2,500 in annual profits for 5 years. This will lead to a total nominal amount of ? 12,500, beginning at the end of the first year. If we use a 4.
5 per cent discount rate in the NPV calculations, the five payments of ? 2,500 equals to ? 10,974. 94 of todays pounds. If we subtract the initial payment of ? 10,000, we’re left with a net present value of ? 974. 94. Now let’s try to do use the same number with the same length of a project, but use 9 per cent discount rate and call it project b. The firm will get a payment of ? 9,724. 13, which means they’ll have a NPV of considerably less, and will in fact end up loosing ? 275. 87 when the project is finished.