Net Present Value Method

The Net Present Value Method (NPV) Method is a discounted cash flow technique. This method compares between cash inflows and cash outflows occurring at the different time period. The major characteristic of this method is that it takes into account the time value of money and all cash inflows and outflows are converted to present value.

Note:

  1. If working capital released in the end and salvage value is given in the question, it must be discounted with the PVF of last year and must be added as a cash inflow in the last years.
  2. The initial outflow is not required to be discounted because it is already a present outflow. But if there is any further cash outflow in the following years like overhauling charges, maintenance charges etc. that should be discounted at PV factor of that year and should be added to cash outflow.

Decision Criteria

  1. If NPV is Positive, the project must be selected. Otherwise rejected.
  2. If there are more than two projects with positive NPV. The project with higher NPV should be selected.

Merits of Net Present Value

  1. This method recognizes the time value of money as cash inflows arising at different time interval are discounted to present values. This is a major improvement over traditional techniques.
  2. This method recognizes risk involved in the project with the help of discounting
  3. This method is best for mutually exclusive projects where only one project is to be selected among many.
  4. In NPV, all cash flows are considered including working capital used and released, salvage value is also considered.
  5. This method is considered best for wealth maximization of shareholders as it is based on cash inflow rather than accounting profit.
  6. It considers total benefits arising out of project till the end of the
  7. The discount rate applied for discounting the cash flows is actually the minimum required rate of return. This minimum rate of return incorporates both the pure return as well as the premium required to set-off the risk.

Demerits of Net Present Value Method

  1. It requires difficult calculation.
  2. The NPV technique requires the predetermination of required rate of return, which itself is a difficult job. If that rate is not correctly taken, then the whole exercise of NPV may give wrong
  3. It does not provide a measure of projects own rate of return, rather it evaluates a proposal against an external variable i.e. minimum rate of return.
  4. The method may not provide satisfactory results in case of projects having different amount of investment and different economic life.