Net Present Value method Essay
Net Present Value method
1. Net Present Value method is one of the methods used in capital budgeting. The NPV is based on the discontinued cash flow. A company that has a proposal for a new project or an investment uses the NPV method to decide if they should accept it or move on with a different investment. This method provides valuable information to the management about the cash outflows related to the investment and cash inflows from the investment with the consideration of the time value of money. The time value of money has been considered in this method because the money invested today will have a different value in the future.
The cost capital is the minimum rate of return that the proposed investment needs to reach in order to be accepted. When computing the Net Present Value the future cash outflows and inflows are discounted at present value at the rate of the cost of capital. If the required rate of return is lower than the cost of capital, then the company should reject the project and should not engage with it any further. On the other hand, if the required rate of return is even or higher, then the investment will be able to bring the profit that will provide founds to pay liabilities to company’s creditor and shareholders.
2. Under Internal Rate of Return the investment is evaluated based on the expected rate of return. The IRR for a cash flow is an interest rate that results in a NPV equal to zero. In this method the cost of capital is used and also known as hurdle rate. Hurdle rate is the minimum rate that the investment needs to reach in order to be accepted by the management. After computing the IRR, the decision making body compares the IRR results to the cost of capital rate. If the IRR is equal or higher that hurdle rate, the investment can be accepted, if lower – project should be rejected.