The Net present value is as the difference between the prevailing present value of the cost inflows and the present value of the cash outflows. When computing the investment net present value, the cash flows going on at unique factors in time are adjusted for the time cost of money the usage of a reduction rate this is the minimum fee of return required for the project to be proper. As Ross (2013) states in his book, a project should be accepted if the NPV is greater than zero and rejected if it is less than zero.
The NPV is computed as follows:
C – the Cash Flow generated in the specific period,
n – time index
N – the last period when cash flows take place
r – relevant discount rate
Note that higher NPVs are more desirable. The specific decision rule for NPV is as follows:
NPV ? 0, reject project
NPV > 0, accept project
“whilst making an investment choice, take the opportunity with the
Highest npv. Choosing this opportunity is equivalent to receiving its npv in cash today” (berk and demarzo, 2017). That is called the npv rule. But, if the npv is zero, the manager has to decide whether to simply accept or reject depending on numerous elements, including there might be a better investment to be made some other place that might produce better return. It will be a que of opportunity cost. The idea of the rule is if a firm accepts an investment with with positive net present value, it’s going to gain the shareholders, because the value of the firm will add (thinking about no different situations) by means of the amount of the npv. That is called additivity, this means that that the value of the company is truly the value of investement, or different projects in the firm.
An organization must not forget the idea of ‘time value of money’ (TVM). TMV means that if £1 is invested today in bank, with an interest of 7% per annum, in twelve months it’ll be £1.07 due to the fact the financial institution compensates the buyers for borrowing their money. Now if you reverse the equation. £1 in 12 months with the equal interest of 7% equals £0.9346 nowadays (Berk and Demarzo, 2017).
The primary advantage with the net present value approach in line with Ross (2013) is that is uses cash flows, it consists of all the cash flows of the project and that it rightly discounts the cash flows well. NPV can handle a couple of discount rate without any problems. Every cash flow can be discounted one by one from the others.
The main drawback to the net present value technique is that it’s sensitive to discount rates. By using surely adjusting a discount rate that is not possible to realize for sure is right or incorrect, a manager can move from creating a profit to losing. All of it depends on whether or not the investment is regarded as safe or not and from there, one may also determine on what discount rate may be handy. It makes a big drawback to the npv rule.
The npv excludes the value of any actual options which could consist within the investement and it does not take acknowledgement to the size of an investement.