Net Present Value

Net Present Value

Due to limited capital resources, two or more projects cannot be pursued simultaneously. It is called mutually exclusive projects that the acceptance of one prevents the acceptance of the alternative proposal. Therefore, mutually exclusive projects involve ‘either-or’ decisions. Therefore, a firm has to evaluate the Net Present Value (NPV) of many projects.

NPV discounts all future project cash flows to the present day to see whether there is a net benefit or loss to firm from investing in the project. If NPV is positive, it will increase the wealth of the firm. If it is zero, the project will return only the required rate return, and will not increase the firm’s wealth. If NPV is negative, it will decrease the value of the firm and should be avoided. The amount of an NPV represents the addition to a firm’s value. Rational management will accept all projects with a positive NPV and reject all negative NPV.

Net Present Value

Advantages

First, it indicates whether the investment will increase the firm's value. Second, it considers the whole life of the project. Third, it considers the time value of money. Fourth, it considers the risk of future cash flows.

Disadvantages

First, it requires an estimate of the cost of capital in order to calculate the net present value. Second, it is relatively complex.

Patricia (2002) reflects the increased financial sophistication and availability of inexpensive computer technology. Firms with larger capital budgets tend to use computer to calculate the NPV. It is generally accepted that NPV is the best appraisal technique, but the surveys show that other approaches are also widely used.

Also, Dayananda argues that NPV is the most appropriate method in the most case to maximize