Net Present Value and Its Comparative Analysis

Net Present Value and Its Comparative Analysis

Abstract

The purpose of this essay is to develop understanding of net present value and its comparison with other methods.  The discussion includes meaning and scope of net present value, which includes the situation in which it may be applied, its advantages and disadvantages.  Methods other than NPV has also been used as part of discussion, they are accounting rate of return, payback period, discounted payback period, internal rate of return method and replacement chain method.  Importance of application of net present value has been discussed.  The cash flow is the prime factor for the calculation of net present values, therefore in the concluding part, factors to be considered at the time of calculation of cash flow of the project has been discussed.

Introduction

Net present value is the difference in the present value of future cash flows.  Present value means the value of money today which is going to be received or paid in future.  It is very simple what you can buy today for $1000, you will not be able to buy after one year with the $1000, and you may buy probably for $1100.  It means that the purchasing power of money has gone down in one year, and the purchasing power relates to the inflation.  One can roughly say that the rate of inflation in one year is 10%.  So if a person receives $100000 from an investment after one year it should be more than or at least equal to today’s 100000, otherwise he will not be able to maintain the purchasing power of the money equivalent to today.  It shows that in determining the value of money, the rate of inflation is the driving factor.  If the rate of inflation is 10%, the present value of $100000 which is going to be received after one year, will be equal to $90909 and if the rate of inflation is 15%, the present value will be 85,957.  Besides inflation rate, other factors are also considered when deciding which should be the discount rate to be used to determine present value of the cash flows.  Based on these factors the discount rate may be interest rate, cost of capital or weighted average cost of capital and desired or required rate of return.

When it is to be decided that what should be the discount rate, the starting point is the interest rate available on risk free security, the present US treasury rate is around 2.5% for 5 year.  For a 5 year project the starting point will be around 2.5%, then the risk associated with the project and the nature of business is added.  The scope of risk will be different from one sector to another; the risk will be different for real estate if it is compared with telecommunication sector.  One also has to take into consideration about various types of business risk, when deciding about the risk factor; they are commodity risk, foreign currency risk, credit risk and operational risk.