Question

​​​​​​​Net Present Value and Other Investment Rules

1. Describe how net present value is used in the financial decision-making process.
2. Explain the disadvantages of using the payback method.
3. Compare and contrast the internal rate of return (IRR) method from the net present value method (NPV).

Answer 1

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Answer 1)

NPV : NPV is one of most used method of capital budgeting to make financial decision. Under NPV we have to compute the cash flow in present value term.

Below is how to use NPV method

1)           Under NPV we have to compute the initial investment and future cash flow.

2)           We also need to compute the cost of capital for the firm.

3)           After computing future cash flow we have to multiply these cash flow by present value investment factor of the cost of capital.

4)           net present value = Present value of future cash flow – initial investment

If NPV if positive project is accepted .

Answer 2)

Disadvantage of using Payback period

1. Payback period does not take care of time value of money
2. Payback period ignore the cash flow received after the payback period

Answer 3)

1. IRR is the implied rate which a project generate at this rate NPV will be zero . NPV is the method which consider the time value of money and compute the present value of cash flow using the cost of capital. NPV = PV of cash flow – initial investment.
2. If project has IRR higher than required rate project is accepted. If project has positive NPV project is accepted.
3. IRR some time may provide two out come under which circumstance its should not be used. NPV is better measure compared to IRR.