Question

Reflect on use of the NPV methodology -its benefits, its shortcomings.

• Why is the NPV tool so powerful?
• What are its shortcomings?
• What data do you need to conduct an analysis using NPV?
• What are other alternative methodologies presented in the chapter and how does NPV stack up against them?
• Have you used this methodology in your work or even in your personal decision when selecting among alternatives?
• How does your firm decide on the discount rate?  
• How careful should the decision maker be in interpreting the results of the NPV analysis?

Answer 1

1. The undeniable advantage of the net present value method is that it considers the essential thought that a future dollar is worth not exactly a dollar today. In each period, the incomes are limited by another time of capital expense.

The NPV method likewise discloses to us whether speculation will make value for the organization or the financial specialist, and by how much as far as dollars. In the model above, we found that the $15,000 speculation would expand the organization's value by $3,443.70 when all incomes were limited back to today.

The last advantages are that the NPV method thinks about the expense of capital and the hazard intrinsic in making projections about what's to come. By and large, a projection of incomes 10 years into what's to come is naturally less sure than incomes anticipated one year from now. Incomes that are anticipated further, later on, have less effect on the net present value than increasingly unsurprising incomes that occur in prior periods.

2. The shortcomings of the net present value method are that it requires some mystery about the association's expense of capital. Accepting the expense of capital that is too low will bring about making imperfect ventures. Expecting an expense of capital that is too high will bring about doing without such a large number of wise speculations.

Moreover, the NPV method isn't valuable for looking at two projects of various sizes. Since the NPV method brings about an answer in dollars, the size of the net present value yield is resolved for the most part by the size of the information.

For instance, a $1 million project will probably have a lot higher NPV than a $1,000 project, regardless of whether the $1,000 project gives a lot more significant yields in rate terms. On the off chance that capital is rare - and it generally is - the NPV method is a poor method to utilize because projects of various sizes are not promptly practically identical dependent on the yield.

3. Cash in the present is worth more than a similar sum later on because of expansion and to income from elective investments that could be made during the interceding time. At the end of the day, a dollar earned later on won't be worth as much as one earned in the present. The rebate rate component of the NPV recipe is an approach to represent this.

For instance, accept that a speculator could pick a $100 installment today or in a year. A discerning financial specialist would not delay the installment. In any case, imagine a scenario in which a financial specialist could decide to get $100 today or $105 in a year. On the off chance that the payer was solid, that extra 5% might merit the pause, however just if there wasn't whatever else the speculators could do with the $100 that would win over 5%.

A financial specialist may be eager to hold up a year to procure an extra 5%, however that may not be adequate for all speculators. For this situation, the 5% is the rebate rate which will fluctuate contingent upon the speculator. If a speculator realized they could procure 8% from a generally sheltered venture throughout the following year, they would not defer installment for 5%. For this situation, the financial specialist's markdown rate is 8%.

An organization may decide the rebate rate utilizing the normal return of different projects with a comparable degree of hazard or the expense of acquiring cash expected to back the project. For instance, an organization may maintain a strategic distance from a project that is required to return 10% every year if it costs 12% to fund the project or an elective project is relied upon to return 14% every year.

Envision an organization can put resources into gear that will cost $1,000,000 and is relied upon to create $25,000 every month in income for a long time. The organization has the capital accessible for the hardware and could, on the other hand, put it in the securities exchange for a normal return of 8% every year. The directors feel that purchasing the gear or putting resources into the securities exchange are comparative dangers.

4. Measuring a speculation's productivity with NPV depends vigorously on presumptions and assessments, so there can be generous space for blunder. Assessed factors incorporate venture costs, rebate rate, and projected returns. A project may frequently require unanticipated uses to get off the ground or may require extra uses at the project's end.

Payback period, or "payback method," is a less complex option to NPV. The payback method computes to what extent it will take for the first venture to be reimbursed. A downside is that this method neglects to represent the time value of cash. Thus, payback periods determined for longer investments have a more prominent potential for mistake.

Besides, the payback period is carefully restricted to the measure of time required to procure back beginning speculation costs. It is conceivable that the venture's pace of return could encounter sharp developments. Correlations utilizing payback periods don't represent the long haul productivity of elective investments.