Net Present Value (NPV) is the important tool used in Finance and under many other industries.
This article will give you the learning’s on “What is Net Present Value?” its definition, formula, advantages and disadvantages.
In this article we’ll discuss the concept NPV in depth and leave you with a solid understanding of the logic and intuition behind the Net Present Value.
Let’s start with the discussion ahead,
What is NPV?
First of all, what exactly is NPV?
Net present value (NPV) is defined as an investment measure that tells an investor whether the investment is achieving a target yield at a given initial investment.
As Company expands, it needs to take important decisions which involve immense capital investment.
A company must take the decisions regarding the expansion of business and investment very wisely.
In such cases, the organization will take assistance of Capital Budgeting tools, one of the most popular NPV method and take a call on the most profitable investment.
Net present value is a tool of Capital budgeting to analyze the profitability of a project or investment.
It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.
As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.
NPV also quantifies the adjustment to the initial investment needed to achieve the target yield assuming everything else remains the same.
The Net Present Value, abbreviated simply as NPV, is one of the most important concepts in finance and commercial real estate.
Compared to the Internal Rate of Return, the concept of NPV is easy to understand, yet it’s also still commonly misunderstood by many commercial real estate and finance professionals.
Formally, the net present value is simply the summation of cash flows (C) for each period (n) in the holding period (N), discounted at the investor’s required rate of return (r):
This is the formula for NPV.
Let’s check out the advantages of Net Present Value.
Advantages of Net present value method
Time Value of Money:
Net present value method is a tool for analyzing profitability of a particular project.
It takes into consideration the time value of money.
The cash flows in the future will be of lesser value than the cash flows of today. And hence the further the cash flows, lesser will the value.
This is a very important aspect and is rightly considered under the NPV method.
This allows the company to compare two similar projects judiciously, say a Project A with a life of 3 years has higher cash flows in the initial period and a Project B with a life of 3 years has higher cash flows in latter period, then using NPV the company will be able to choose sensibly the Project A as inflows today are more valued than inflows later on.
NAV takes into consideration all the inflows, outflows, period of time, and risk involved.
Therefore NPV is a comprehensive tool taking into consideration all aspects of the investment.
Value of Investment:
The NAV method not only states if a project will be profitable or not, but also gives the value of total profits.
The tool quantifies the gains or losses from the investment.
All the above mentioned points are the advantages of Net Present Value.
Now, you’ll get to know about the limitations of Net Present Value Method.
Limitations of Net Present Value
The main limitation of Net present value is that the rate of return has to be determined.
If a higher rate of return is assumed, it can show false negative NPV, also if a lower rate of return is taken it will show the false profitability of the project and hence result in wrong decision making.
Different Projects are Not Comparable
NPV cannot be used to compare two projects which are not of the same period. Considering the fact that many businesses have a fixed budget and sometimes have two project options, NPV cannot be used for comparing the two projects different in period of time or risk involved in the projects.
The NPV method also makes a lot of assumptions in terms of inflows, outflows. There might be a lot of expenditure that will come to surface only when the project actually takes off.
Also the inflows may not always be as expected.
Today most software perform the NPV analysis and assist management in decision making.
With all its limitations, the NPV method in capital budgeting is very useful and hence is widely used.
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