NPV
NPV (the net present value) is used to calculate, and analyze how much is a project is useful also to find out the difference between the present value of cash inflows and the present value of cash outflows. Also, we should know that the NPV analysis is sensitive when we calculate the future cash inflows for the project's revenues. Simply the NPV method shows whether we should undertake a project or reject it; it is useful to make decisions and it is easy to use.
According to the primary investment rule, if the NPV is positive that means the project or the investment worthwhile, besides if the NPV is negative, that means the opposite and the project should not be accepted as this means the project not useful. Furthermore, when it is 0, it means that there is no different in the present value of the cash outflows. Therefore, the rule assists the investors in making the right decision before starting any project. This is achieved through the method’s ability to help the investor know if the project will make profit and, therefore, avoid any losses. There are other methods, but they are not accurate as the primary investment.
There are many advantages off the NPV. First, it allows the investor to compare between the projects in order to pick the best project which guarantees the highest profit value. If none shows a good profitability value, the investor will avoid them. Another benefit is that the NPV is considered the most important method in calculating the current value of the money. The reason for this is that the value of the money changes over time. NPV puts into consideration both the cash flow after and before through-out the investment's life. It helps maximize the firm's value and profitability. Risk of the investment is given a high priority by the NPV. Firstly, the cash flows in the NPV mean both the outflow and inflow of money involved in the project. This includes money that is either related or not to the project and are used for other goals for other businesses. Secondly, the cash flows in the NPV are used for all investment whether it is a short-term or long-term investment. Use of NPV is more advantageous as compared to other methods such as, Payback method, which has 'cut-off' periods where they calculate the investment for a short time and the period after the cash flow are ignored.
In additional to that, the discounting cash flows is another benefit. Other methods ignore the time value of money. This is because their cash flows, more often than not, give investors an unrealistic analysis of the profit that can be gained from making investments. A good example of a method that does so is the payback method. NPV helps to maximize the business value. The higher the NPV, the better the project and; therefore, it translates to an increase in the business value. For this reason, the NPV is considered as the most important and useful method. For example, assume an investment has 10 % annual return and 100,000 NPV, whereas another investment has 7 percent annual return and 150,000 NPV that means the second one will add value regardless of the lower rate of return.
They say that the NPV is not that effective to help the business in the current time. When NPV is applied to risk-based valuation, it goes through two main limitations. First one is the improvement that is made by the finance market to divide cash and risk. After this stage, the cash investment emerges as one with less risk than it was before going through the stage. Cash investment could still have a risk even if the value were equal to zero. However, in current capital markets cash investments do not have to be related to the risk. It has been stated by suppliers who have small spread to risk-free interest rates that an investment that matches the right agreements is possible to meet its cash requirements. Second, because we compute the NPV from expected cash flows, the diversifiable risk on asset valuation impact is ignored. Furthermore, not all investors are able to ignore it, just well-diversified investors. Nevertheless, those kinds of investments do not occur in the market industry. Hence, when they are assessed through asset valuation risk factor has to be put into consideration.
Ross, S (1995) suggests that three factors have to be considered when using NPV to decide whether to accept or reject an investment or the project. These are; the good, the bad and the ugly.
The good occurs when a project that should be rejected is, in actual fact, rejected. If an investment is controlled by capital market option, then taking on the controlled investment would not be justified by financial considerations. This is because capital market alternatives are freely available and even if the alternative is used it does not mean that the alternative is available for the investor. Hence, it is obvious to reject a project when it does not make a huge profit when there are many other projects which more profitable and available.
The bad occurs when a project that should be rejected is accepted. The NPV rule follows that the project should be rejected when it is less than a zero. Many investors reject a project only when it is a negative; however, that does not mean it will stay the same in future as we know the money value changes over time. For example, if, in the future, the interest rates decrease, this would lead to the NPV increasing to become a positive number. Moreover, many projects include more than one investment through their lifetime. Thus if the interest rate does not make the project worthwhile at the time, might not be stay the same in the future. Investors should not reject an investment if the NPV is negative. This is because when an investment is taken under an optional interest rate, the negative NPV will become positive once the project is undertaken. Hence the interest rate does not increase the investor will be able to profit from the increasing NPV thus will have limited liability.
The ugly comes in when an investor accepts an investment when it should be rejected. According to the NPV rule, a project should be accepted when it is positive. Many investors accept a project with positive NPV without thinking that there might be other investments that are worthwhile and available. If they accept an investment which has to be rejected, the future and current profit will be affected. The time value of the money is one of the weaknesses of the NPV because the project competes with itself as time goes on
Payback
NPV is not the only valuation tool used. The most famous alternative is the payback method of calculating valuation. NPV calculates the profit that can be made from an investment; however, the payback method is used to calculate how long the investment will take to recover initial investment. The initial investment is known as the cash outflows and the return and revenue made by the investment are called cash inflow. For example if it takes 3 years to recover the costs incurred in setting up an investment, the payback period is the 3 years (Hillier et. al., 2010, p.150).
Usually, the payback method is used by small businesses for small decision making processes. Large businesses also need to make a small decision once in a while, and the payback method helps in these cases too. This is because it is easier to use due to the fact that it saves time. It is not only important just because it used to make adecision, also because it is important in testing the manager’s ability to choose the right investment. NPV approach takes a longer time compared to the payback method. Before any decision made if the manager has made the right decision, whether accepting or rejecting the project, the investment has to finish its time duration. With the payback method, only some years will be needed so as to know whether the manager made the right decision on such an investment or not.
However, there are three problems associated with the payback method. These include timing of cash flows within the payback period, payments after the payback period and arbitrary standard for the payback period. The payback method only considers the how long an investment will take to recover the investment's cost. It does not put the timings of the cash flow within the payback period into the consideration. That is why timing of cash flows within the payback period is one of the problems of the payback method. Both the payback method and the NPV approach do not consider the timing of cash flows; however, the NPV discounts the cash flows properly.
Any investments made after the payback period should be ignored and that is why payments made after the payback period could be a problem. For example if there is an investment that shall payback itself in two years, any payments made after the two years should be ignored. Thus, when accepting or rejecting an investment, we should not consider the payments after the payback period. For this reason, it is likely not to accept long-term investments. Lastly, the arbitrary standards for a payback period are a problem as the payback does not estimate when it comes to choose payback cut-off date, and it is done randomly. On the other hand with the help of the capital market, we can estimate the discount rate used in the NPV.
Another one of the disadvantages that the payback period has is that people who make the decisions use the discount period method, use it as an alternative and they use it when cash flow has been discounted. They then start calculating how long it will take to discount the cash flows so as to recover the initial investments.
