Question

Describe how net present value is used in the financial decision making process. Explain the disadvantages of using the payback method.

Answer 1

Net Present value method: The Net present value method of financial decision making considers the time value of cash flows occurred at different future dates and convert such cash flows into their present value ( i.e. the value of cash flows at Year-0) taking into consideration discount rate and Year in which such cashflows occurs. The present value factor shall be determined for each such cash flows (after taking discount rate and Year of occurrence) and such Present value factor is applied on respective cash flows to arrive at the present value of cash flows. The sum of such present value of cash flows is net present value of project. when the Net present value is positive, the project is acceptable and if net present value is negative, the project must be declined.

Disadvantages of payback period:

The main disadvantages of payback period is as under:

*It does not take into consideration the present value of cash flows i.e. cash flows occurring in different time periods are considered as equivalent.

* The Pay back period does not take in to consideration the cash flows which could be generated from the project after the pay back period is over.