Question

3 Explain the process of determining Net Present Value (NPV) when evaluating a capital investment and outline the decision rules. Compare and contrast PP and NPV as decision support tools. 4.

Answer 1

3) Net present value refers to the difference between present value of future cash flows and initial investment. Present value of cash flows is computed by discounting the future cash flows with a given discount rate.

NPV is computed using the following equation-

NPV = Present value of future cash flows - Initial investment

Using NPV a project is selected to invest if present value of future cash flows exceed the initial cost or in other words if NPV is positive.

And, on the other hand project is rejected if initial cost exceeds the present value of future cash flows or in other words if NPV is negative.

Cash flows are discounted by using the PVIF (Present value Interest Factor)

Where,  

PVIF_{(r%, n)} = 1 / (1+r)ⁿ

^{For example: Present value of $100 which is expected to receive in 5 years from now and given discount rate is 10%, then it will be computed as follows-}

^{Present value of cash flow = CF × PVIF_{(10%, 5)}}

^{_{= $100 × [1 / (1 + 0.10)}5}]

= $100 × 0.621

= $62.10

So in order to compute the present value of future cash flows compute their present value as above and then take the sum of all present value of future cash flows and put the value in NPV equation.

4) Payback period refers to the length of time period required to recover the initial investment. Both NPV and PP is equally important in decision making, using payback method the computed payback period is compared with the useful life of project to see whether project is able to recover its initial cost within the useful life of the project or not. Where in NPV metod present value of cash flows is computed to compare the initial cost and present value of cash flows. Therefore, both methods are distinct and have different decision rules.

In PP method project is selected when computed payback period is less than the useful life of the project.

And in NPV method project is selected when NPV is positive.

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