Technique for analyzing capital investment projects are known as Net Present Value (NPV). A project's net present value is the amount by which the project is expected to increase the wealth of the firm's current shareholders. Net present value techniques involve projections of future volume and value increases and calculations of present value based on the cost of investing ones capital in the given periods of time. A dollar today is worth more than a dollar in the future, because inflation erodes the buying power of the future money, while money available today can be invested and grow. .
The Discount Rate is the rate of return which could be obtained if the initial outlay were invested on the money market. Since the discount rate reflects the future value of money, it typically has two components: an adjustment for inflation, and a risk-adjusted return on the use of the money. Since market forces typically incorporate inflation adjustments into investment returns and borrowing costs, often the discount rate is keyed to a standard reference rate.
Some Advantages and disadvantages are:- .
Advantages:- .
• It will give the correct decision advice assuming a perfect capital market. It also gives correct ranking for mutually exclusive projects unlike the IRR.
• NPV gives an absolute value.
• NPV allows for the timing of the cash flows.
Disadvantages:.
• Calculating NPV is difficult, in part, because it isn't clear what discount rate should be used, nor is it clear how to project future changes in the discount rate.
• NPV, of all the 4 methods of Investment appraisal, requires the decision criteria to be specified before the appraisal can be undertaken.
Net Present Value Analysis:- Regardless of the application, we should use this 5-step process in net present value analysis:.
Step 1 - Select the discount rate.
Step 2 - Identify the costs/benefits to be considered in analysis.
