Discuss Net Present Value (Npv) Payback Has Certain Advantages, But Disadvantages For Long Term Project Appraisal. Discuss.

1289 words - 5 pages

INVESTMENT APPRAISALCharacteristically, a decision to invest in a capital project involves a largely irreversible commitment of resources that is generally subject to a significant degree of risk. Such decisions have far-reaching effects on a company's profitability and flexibility over the long term, thus requiring that they be part of a carefully developed strategy that is based on reliable appraisal and forecasting procedures.In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the life span of the investment, the degree of risk attached and the cost of obtaining funds.One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional and discounted cash flow techniques. Traditional methods include the Average Rate of Return and Payback; discounted cash flow (DCF) methods using Net Present Value and Internal Rate of Return.NET PRESENT VALUE (NPV)Net present value is a way of comparing the value of money now with the value of money in the future. A euro today is worth more than a euro in the future, because inflation erodes the buying power of the future money, while money available today can be invested and so grow.The technique is a three-stage process:to calculate the present value of each element of cash expenditure in a proposal and then, to add these individual present values together to provide a total present value of the expenditures;to similarly calculate the present value of each element of cash income in a proposal and, then, to add these individual present values together to provide a total present value of the incomes;to deduct the total present value of expenditures from the total present value of the incomes, in order to determine the net present value;If this calculation produces an NPV that is positive, the signal is to accept the proposal. If, however the NVP is negative, the signal is to reject the proposal.YearProject ACash flow Project BCash flow130.0005.000225.00025.000325.00025.00045.00025.00055.00020.000(Estimated cash flow, initial outlay of 50.000)The next figure sets out a present value analysis of both projects. The discount rate used is 14 per cent.Project AProject BYearNet cash flowDiscount rateNPVNet cash lowDiscount rateNPV0(50.000)1,0(50.000)(50.000)1,0(50.000)130.0000,877226.3165.0000,87724.386225.0000,769519.23825.0000,769519.237325.0000,675016.87525.0000,675016.87545.0000,59212.96025.0000,592114.80255.0000,51942.59720.0000,519410.388Total17.98615.688Excess present value index: 17.986 / 50.000 = 0,3615.688 / 50.000 = 0,31We can see that both these projects have positive net present values when discounted at 14 per cent and therefore are both acceptable. However, if only one of the projects can be undertaken (for whatever reason), project A...

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