The investment process plays an important role in the economy of any country. Investing largely determines the economic growth of the state, employment level and constitutes an essential element of the base of the economic development of society. Therefore, the problem associated with the effective implementation of the investment merits serious attention, especially at the present time - the time of globalization of the subjects of market relations. It should be noted that the investment activity in modern conditions is closely linked with the ability to develop an effective investment plan or project and then provide some of their resource constraints and to implement a given level of quality of the project products. In this regard, the question of the need to ensure effective project management raises.
Companies are investing in a variety of real assets that are tangible, like machinery and equipment, and intangible, as contracts with the managers or patents. The purpose of investment decisions (in the area of budget planning solutions) consists in finding those assets whose value exceed the price paid for them.
Net present value is the difference between the sum of the discounted present value of all the tributaries and the sum of the discounted present value of all the outflows of the project (Megginson & Smart, 2005). Net present value can be calculated as follows:
NPV=i=0n(CIFi-COFi)1+ri
where: NPV is a net present value of the project;
r is a discount rate;
CIFi is cash inflows for the i-th period;
COFi is cash outflows for the i-th period;
n is a planning horizon.
If the realization of assets is not considered as one of the project development alternatives, it is possible to do the NPV calculation solely on the basis of discounted net cash flows. If the developer of the project suggests the possibility of the implementation of business and this is one of the alternatives of the project, it justifies the inclusion of the residual value of the tributaries of the period n.
Evaluation of the effectiveness of projects carried out in the following manner (Schenk, Wirth & Muller, 2010):
for an independent project: if NPV> 0, the project is accepted;
for several alternative projects: the project with the highest value of NPV (if it is positive) is accepted.
It should be particularly commented that where NPV = 0, the value of the firm does not change, but at the same time, it increases production, i.e. company will increase in scale. If this is a positive development, the project could be accepted.
The value of NPV indicates whether the project inflows received during the reporting period of time are sufficient (acceptable, significant) compared to the expected level of return of capital. However, as can be seen from the formula, NPV value greatly depends on the discount rate because it is calculated on the basis of the discount rate. For different values of this rate, the NPV of the project can be both positive and negative values. Logically, the result of the project may be positive and negative at one and the same time. The evaluation of these results also may be different. Thus, when interpreting the essence of NPV, it is more correct to speak not about the result of the implementation of the project, but about the evaluation of results. The absolute result of the implementation of the project (Net Value, NV) will not depend on the discount rate and will be expressed in the value of the accumulated undiscounted net cash flows.
Now let’s consider the possible applications of the NPV concept that possibly will be useful for me in my future business career. Consider the following fictitious example. The company has two options to invest $200,000 in two different projects. In the first case, the company invests in fixed assets, purchasing new equipment, which after 6 years (the term of the investment project) could be sold for $14,000; net annual cash income from such investments is estimated at $53,000.
According to the second option, the company can invest the money partially ($40,000) in the acquisition of new equipment. The remaining amount of money can be invested in working capital (inventories, an increase in accounts receivable). This will generate $34,000 annual net cash income over the same six years. It should be noted that at the end of this period, working capital is released at the same value (inventories are sold, receivables accounts are closed).
Which option should is better to choose, if the company expects a 14% return on invested money? Use the method of net present value:
The first option:
NPV=-2000001+0.140+530001+0.141+530001+0.142+530001+0.143+530001+0.144+530001+0.145=$12,477.60
The second option:
NPV=-2000001+0.140+340001+0.141+340001+0.142+340001+0.143+340001+0.144+34000+1600001+0.145=$5,108.50
Since we got positive net present values, we conclude that these projects are both profitable. Based on the criterion of maximum net present value, the company should implement the first option.
The advantages of NPV are already shown above. However, NPV has some disadvantages (Von Quintus & Killingsworth, 1997). The disadvantage of this indicator is NPV is an absolute indicator of efficiency. It gives the answer to the question, whether the analyzed investment option increases the value of the investor's wealth, but it does not say anything about the relative extent of such growth. However, the relative indicators are always important for any investor. This indicator cannot help the investor to compare projects with the same level of NPV, but with different levels of outflows.
References
Megginson, W., & Smart, S. (2005). Introduction to corporate finance (p. 335). Southbank, Vic.: Thomson/South-Western.
Schenk, M., Wirth, S., & Muller, E. (2010). Factory planning manual (p. 305). Heidelberg: Springer.
Von Quintus, H., & Killingsworth, B. (1997). Design pamphlet for the determination of design subgrade in support of the 1993 AASHTO guide for the design of pavement structures (p. 51). McLean, VA: U.S. Dept. of Transportation, Federal Highway Administration, Research and Development, Turner-Fairbank Highway Research Center.
