Net Present Value Method (NPV)
Under this method, all future cash inflows (benefits) and cash outflows (cost) are
discounted to present values. Then the present value of cash outflows is deducted
from the sum of the present value of cash inflows. The balance amount is the NPV.
The NPV may be either positive or negative. If the NPV is positive, it means that the
actual rate of return is more than the discount rate. A negative NPV indicates that the
project is not even covering the cost of capital. It means that the actual rate of return
is less than the discount rate.
Computation Procedure of NPV
The following steps are involved in the computation of NPV:
1. Determination of minimum rate of return: To discount the cash flows a minimum
rate of interest should be selected. This is generally the firm's cost of capital
(i.e., the minimum rate of return an investor expects from the firm to earn on the
proposed investment).
2. Computation of PV of cash inflows and outflows: With the help of the minimum
rate of return, the present value of cash inflows (return or benefit) and the
present value of cash outflows (cost or amount of investment) should be
computed. As investment in the project is made at the beginning of the period,
its cost (cash outflows) itself is the present value. The present values of cash
flows for different years may be calculated with the help of the following formula:
where, C1, C2, Cn= Cash inflows for n years,
r = Discount factor or interest rate
n = Number of years
Note: In practice, the present values are not computed with the help of above formula.
For this, "Present Value Table" is used. The formula for computation of present value
is as follows:
PV = Cash inflow x Discount factor of the concerned period.
(c) Computation of NPV: The difference between total present value of cash inflows
and total present value of cash outflows should be found out. The resulting amount is
the net present value (NPV).
Decision Rule (or Selection Criterion): In the case of mutually exclusive or alternative
project, (where only one project is to be selected) accept a project that has the highest
positive NPV.
In the case of independent investment, accept a project if its NPV is positive. If the
NPV is negative, reject it.
Advantages of NPV Method
1. It takes into account the time value of money.
2. It considers the cash flow stream over the entire life of the project.
3. It focuses attention on the objective of maximisation of the wealth of the firm.
4. This method is most suitable when cash inflows are not uniform.
5. It is highly useful in case of mutually exclusive projects.
Disadvantages of NPV Method
1. This method may not provide satisfactory results in case of two projects having
different useful lives.
2. This method is not suitable in case of projects involving different amounts of
investment.
3. Different discount rates will give different present values. As such, the relative
desirability of projects will change with a change in the discount rate.
4. It is difficult to select the discount rate.
5. It involves complicated calculations.
Profitability Index Method (or Discounted Benefit Cost Ratio)
Two projects having different investment outlay cannot be compared by net present
value method because it indicates the NPV in absolute terms. In such a situation,
profitability index method should be applied. Profitability index is the ratio of benefits
(cash inflows) to cost (cash outflow). It is the ratio of present value of cash inflows to
the present value of cash outflows.
Decision Rule (or Selection Criterion): Under PI method the decision rule is "accept
the project if its Pl is more than one and reject the project if PI is less than one".
Advantages of Profitability Index Method
1. It is very scientific and logical.
2. It considers the fair rate of return.
3. It is useful in case of capital rationing.
4. It is very useful to compare the projects having different investments.
5. It reflects time value of money.
6. It considers all cash flows during the life of the project.
Disadvantages of Profitability Index Method
1. This method is not in accordance with accounting principles and concepts.
2. It is comparatively difficult to understand and follow
3. It is difficult to estimate the effective life of a project.
4. It cannot be used for comparing those projects having unequal lives.
5. It is not useful when many small projects have to be aggregated and compared
with a large project
Internal Rate of Return (IRR)
Net present value method indicates the net present value of the cash flows of a project
at a pre-determined interest rate. But it does not indicate the rate of return of the
project. In order to find out the rate of return of a project, estimated net cash inflows of
each year are discounted at various rates till a rate is obtained at which the present
value of cash inflow is equal to the initial investment or the net present value comes
to zero. Such a rate is called internal rate of return or marginal rate of return. It is also
called time adjusted rate of return.
Decision Rule (or Acceptance Criterion): The calculated internal rate of return is
compared with the desired minimum rate of return (cut-off rate). If IRR is equal to or
greater than the desired minimum rate of return, then the project is accepted. If it is
less than the desired minimum rate of return, then the project is rejected.
Advantages of IRR
1. This method considers all the cash flows over the entire life of the project.
2. It takes into account the time value of money.
3. Cost of capital need not be calculated.
4. IRR gives a true picture of the profitability of the project even in the absence of
cost of capital.
5. Projects having different degrees of risk can easily be compared.
Disadvantages of IRR
1. The IRR method is difficult to understand and use in practice because it
involves complicated calculation.
2. Under certain conditions it becomes very difficult to take any decision.
3. Sometimes it may yield negative rate or multiple rate which is rather confusing.
4. It yields results inconsistent with the NPV method if projects differ in their
expected life span, and investment timing of cashflows.
5. It is applicable mainly in large projects.
Net Terminal Value Method (NTV)
This method is based on the assumption that each annual cash inflow is received at
the end of the year and is reinvested in another asset at a certain rate of return from
the moment it is received till the termination (end) of the project. Now the total
compounded sum is discounted at the discount factor of the last year (cost of capital)
and present value is found out. This total present value is compared with cost of project
or initial investment. The excess of the present value over the cost of the project is the
Net Terminal Value (NTV).
Advantages of Terminal Value Method
1. It is a simple technique of project appraisal.
2. It is simple to understand.
3. It avoids the influence of cost of capital.
4. It is more suitable for cash budgeting.
Disadvantages of Terminal Value Method
1. It is difficult to project the future rates of interest.
2. It does not consider the comparative evaluation of two or more mutually
exclusive projects.
