Investment Appraisal - Net Present Value 3.3.2

Investment Appraisal - The use of numerical techniques to predict the financial outcomes of potential capital investments.
Net present value - The difference between the present value of the future cash flows and the amount invested in the project.

FORMULA  - NET PRESENT VALUE

EACH NET CASH FLOW MULTIPLIED BY THE DISCOUNT FACTOR WHICH WILL GIVE YOU THE NPV

ADD UP ALL THE NPV'S

POSITIVE = ACCEPT PROJECT

NEGATIVE = REJECT PROJECT

 

Interpreting NPV allows for close attention to the value of the return in today's terms so is a more realistic view of any investment. Different interest rates can be applied to reflect the expectations of different investors. After applying the discount factors, the NPV could be positive, which may suggest it is a worthwhile investment, or negative, in which case the investment should be rejected.

Advantages	Disadvantages
Considers all future cash flows	The most complicated method compared with Payback and ARR
Reflects the risks that future cash flows will not be as expected.	Choosing the discount rate is hard, particularly for long prospects
Different levels of risk can be accounted for by adjusting the discount rates	Result can be influenced/manipulated using the discount rate
Creates a straightforward decision – positive NPV suggests project should go ahead	Complex calculation so difficult to convey to investors and therefore misunderstood
Includes the fact that it takes into account the opportunity cost of money, as well as the timings and amounts of cash flow.	Projects can only be compared if initial investment is the same.