Re: Please help!
The net present value method
Investment decisions are very important to a business. They tend to involve large sums of money and their impact on the survival and prosperity of the business can be profound.
Once an investment decision has been made, and the funds committed, it is often difficult to abandon the project without significant losses being incurred.
It is therefore important that investment proposals are properly evaluated before a final decision is made. In practice, there are four major methods of evaluating investment proposals:
• Accounting rate of return (ARR)
• Payback period (PP)
• Net present value (NPV) method
• Internal rate of return (IRR).
The first two methods are the traditional methods of appraising investments and have been around for many years. The NPV method is a more recent development. This method discounts the future cash flows associated with the investment project using the cost of capital as the appropriate discount rate. The decision rule is that if the net present value of the discounted cash flows is positive, we should accept the project.
It is important to be aware of the advantages of this method over the ARR and PP methods. The most important advantages of the NPV method are that it:
• takes account of the time value of money, by discounting the cash flows arising in the future
• takes account of all relevant cash flows
• provides a clear decision rule concerning acceptance/rejection of a project
• is consistent with the objective of maximising shareholder wealth, which is assumed to be the primary objective of a business.
The IRR method is the last method listed above and is similar to the NPV method. It is based on the principle of discounting future cash flows and will normally give the same accept/reject decisions and will rank investment projects in the same way as the NPV method. However, the IRR method has difficulty in handling unconventional cash flows and does not address the issue of wealth maximisation as well as the NPV method. Thus, from a theoretical viewpoint, the IRR method is inferior to the NPV method. However, it seems that managers prefer the IRR method to the NPV method. This is perhaps because it provides an answer that is expressed as a percentage figure, which is easier to understand than present value pounds.
Some practical issues
From the above we can see that, if the objective of the business is to maximise the wealth of its shareholders, the NPV method is theoretically the best method to use. The general principles of the NPV method are fairly straightforward. However, the practical application of this method can cause problems. Thus, when dealing with questions relating to this method, the following points should be borne in mind.
1. Relevant costs
Only future costs that vary with the decision should be included in the analysis. This means that past costs and committed costs should be ignored because they cannot vary with future decisions concerning the investment.
2. Opportunity costs
Opportunity costs do not result in cash movements. Nevertheless, they should be taken into account as they represent real benefits foregone.
3. Taxation
Investors are concerned with the after-tax benefits from their investment. This means that, where taxation information is provided in a question, it must be taken into account. The after-tax cash flows from an investment should be discounted using the after-tax cost of capital.
4. Cash flows
In NPV analysis, it is cash flows rather than profit flows that are used because it is the former that gives a business command over resources. In some cases however, a question may provide information concerning future profits rather than future cash flows. When this occurs, it is necessary to convert the profit flows into cash flows, which can be done by adding back any non-cash items appearing in the profit and loss account. The most common example of a non-cash item is depreciation.
5. Working capital
Where profit flows are converted into cash flows, some adjustment may be necessary in respect of the investment in working capital over the period of the project. Any addition to working capital will be treated as a cash outflow and any release of working capital will be treated as a cash inflow in the period in which it occurs.
6. Interest payments
Interest payments are not deducted in arriving at the relevant cash flows for the investment project. The cost of financing is taken into account in the discount rate (which is based on the cost of capital) and so should not be taken into account again when deriving the relevant cash flows.
