Hypothetically, business or organization should invest in all projects and opportunities that enhances shareholders value. However, because of the limited capital available for new projects, organization often faced ‘economic problem of choice’ in selecting ‘which project or equipments among many’ available options have the highest expected returns to receive investment funds. To do this, management adopts capital budgeting techniques to determine the most profitable project either by life span or by returns. Capital is the total investment of the company and capital budgeting is the art of evaluating how company capital will be efficiently utilized. Capital budgeting allows companies to analyse one or more projects to decide eventually which project or equipment would be most profitable, according to the needs and capacity of the company.
Capital budgeting decision is an important aspect for firms future operations. This is because it has a huge impact on the future cash flows of the organization with respect to competitions for the firm if the decisions failed to plan carefully.
Capital budgeting techniques can be categorised into two. The discounted cash flow method that includes; the NPV method, profitability index method and IRR. The Non discount methods, includes; Payback period and Accounting rate of return method.
Definitions, explanations and calculations related to capital budgeting such as Net Present Value(NPV), Internal Rate of Returns(IRR), Accounting rate of returns (ARR),……… Would be provided as well as their comparison with Net present value, in this research essay.
Net Present Value (NPV)
NPV is the difference between the present value of cash inflows from an investment , and the present value of cash outflow( Business dictionary,2011). NPV is used in investment to analyze the profitability of project. Companies often use NPV as a capital budgeting technique because it’s perhaps the most insightful and useful method to evaluate whether to invest in a new capital project. NPV is one of many capital budgeting methods used to evaluate potential physical asset projects in which a company might want to invest. Net present value analysis involves the use of several variables and assumptions to evaluates the cash flows forecasted to be delivered by a project by discounting them back to the present using information that includes the time span of the project (t), and the firm’s cost of weighted average cost (capital).
There are different types of investment project, and the decision whether invest in a project depends on the nature of that project. In an independent project, if the result is positive (NPV greater than 0), then the firm should invest in the project, if negative, the firm should not invest in the project. In a mutually exclusive projects, a project is worth investing on if its NPV is greater than other alternative options.
To calculate the NPV ;
Add the initial investment on the project, to the rest of the project cash flows.
The initial investment is an outflow, and so it must be a negative number. The formula for
calculating the Net present value of a project is given below:
NPV = -CF(0) + CF(1)/(1 + I)t + CF(2)/(1 + I)t + CF(3)/(1 + I)t +……….. CF(n)/(1 + I)n
I = firm’s cost of capital
F(n) = the cash flow at time n
t = the year in which the cash flow(s) are received
CF(0) = initial investment.
Net Present Value Decision Rules;
Like any other capital budgeting techniques, Net present value has its own decision rules.
Independent projects: If NPV is greater than 0, accept the project (profitable).
Mutually exclusive projects: For mutually exclusive projects, If the NPV of one project is
greater than the NPV of the other project(s), accept the project with the higher NPV. If both
projects have a negative NPV, reject both projects.
Example: invest £2000 now, receive 3 yearly payments of £100 each plus £2500 in the third
year with 10% interest rate.
Co = -2000
C1 = 100
C2 = 100
C3 = 100
R = 10% (0.10)
NPV = 2000 – 100/1.10 + 100/1.10^2 + 100/1.10^3 + 2500/1.10
= 2000 – 90.91 + 82.64 + 75.13 + 1878.29
Decision : investment looks good, accept the proposal.
Advantages and Disadvantages of Net present value
Net present value (NPV) has many advantages when it is used as a criterion for accepting or rejecting project in capital budgeting. But although NPV offers insight, and a useful way to quantify a project’s value and potential profit contribution, it does have its own downsides. Since no analyst has a sixth sense of the future expectation, every capital budgeting method suffers from the risk of incorrectly estimated critical formula inputs and assumptions, as well as unforeseen events that can affect a project’s costs and cash flows.
NPV produce a money amount that indicates how much value the project will create for the company. Stockholders can see clearly how much a project will contribute to their wealth. The biggest problem with NPV is that it requires guessing about future cash flows and estimating a company’s cost of capital and not the real return on investment(s).
The most important feature of the net present value is that it is based on the idea that money received in the future are worth less than money received in bank today. Cash flows from the future years is discounted back to the present to find their worth. NPV method is not applicable when comparing projects that have different initial cost of capital. A larger project that requires more money should have a higher NPV, but that doesn’t necessarily make it a better investment, compared to smaller project.
The calculation of NPV uses the company cost of capital as the discount rate. This is the possible expected return that shareholders requires for their investment in the company. The problem with NPV approach is that it is difficult to apply when comparing projects with different lifespans. How do you compare a project with life span of five years with positive cash inflows with a project that is expected to produce cash flows for 20 years.