Net present value
NPV is gotten by subtracting cash outflows from the sum cash inflows from the project investment. To get current values, a discounted rate used which is the rate of return or the opportunity cost of capital. The opportunity cost of capital is the rate of return that an investor could earn if the money would have invested in financial assets of equal risk (Gollier, 2009). It’s therefore, the return that an investor would expect to receive. It’s vital in capital budgeting because of the determination of the expected profits from the projects to be invested if approved by the management.
When calculating the NPV, the cash flows are used, and this implies that non-cash items such as depreciation if included in the cash flows, should be adjusted. In the computation of the NPV the following steps followed; cash flows of the investment should be forecasted based on realistic assumptions. If sufficient information is given one should make the appropriate adjustment for non-cash items; identify appropriate discounting rate; compute the present value of cash flows established in the first step using the discounted rate in the second phase. NPV will, therefore, found by subtracting the current value of cash outflows from the present value of cash inflows. In the decision making, when NPV is positive or greater than zero, the firm will earn a return higher than its cost of capital, thereby enhancing the market value of the enterprise and shareholders wealth. Those projects with the positive net present value will earn profits unlike the ones with negative net present value that anticipated that they will make losses, and therefore only those projects with positive net present value should be acceptable.
Because there are some ways that the future cash flows can be measured, it becomes difficult to determine the real value of the project; this is because of the time value of money, where the money today has greater value than the money of the same value tomorrow (Peterson Drake & Fabozzi, 2009). This difference explained by prevailing inflations in the market. To try solving this, discounted rate used in the net present value caters for the expected future changes as a result of inflation. Net present value, therefore, takes into account time value of money.
Net present value has some drawbacks because it depends so much on estimates and assumptions. From this, it means that it gives room for errors. Some of the estimated factors include; returns from the projects, discounted rate and costs associated with the investment. Unforeseen expenditures needed by the project or at the end of the project, more expenses may be necessary. Estimates of the cash inflows and the associated discounting rates may not inclusively take into account the risks involving the projects but only focuses at the maximizing the cash inflows of the project in an investment period; this temporarily increases the confidence of the shareholders. The adjustments will, therefore, be necessary to cater for such unknown costs or overestimated cash inflows expected from the projects.
Initial investment = $100,000
TOTAL CURRENT VALUE=27273+30576.8+12020.8+12294+9934.4+8467.5
=$100,566.50
NET CURRENT VALUE = cash inflows- cash out flows
= $100,566.50 - $100,000
= $566.50
The Degree project should be accepted because it has a positive net present value of $566.5
References
Gollier, C. (2009). Expected net present value, expected net future value, and the Ramsey rule.
Munich: CESifo.
Peterson Drake, P. & Fabozzi, F. (2009). Foundations and applications of the time value of
money. Hoboken, N.J.: John Wiley & Sons.
