A rational capital budgeting functionality should answer two major questions. First is that, whether one particular project is a good one? Second, if we get more than one available project opportunities, but we should choose only one of them, which one should be that “one”? In real life we very frequently come across with question like whether to pick up a lump some payment of retirement account accumulated during years or receiving monthly retirement pensions until the rest of our life. In this case, NPV is the most appropriate answer out of two or three most widely used techniques in capital decision making.
While doing so we also should keep in mind two major features of NPV: 1) in monetary terms, NPV is the difference between today’s market value of the investment and its original cost. 2) a financial manager should always act on behalf of the interests of shareholders through distinguishing and picking up projects with positive NPV, since it’s very clear that the ultimate target of any investment is the maximization of owners’ wealth. Another major characteristic of NPV is that they cannot be straightforwardly originated in the market, so they need to be estimated.
Since there’s always the possibility of a poor estimation, financial managers need to use a number of other criterions for project evaluation for additional information regarding whether or not an investment has a positive NPV indeed. (fundamentals corporate finance) Internal rate of return and payback period are the major evaluation tools used by supervisors as an alternative to NPV. It might be feasible to use mentioned methods during evaluation process as well, however each of these methods has very significant shortcomings.
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For example: Major drawback of IRR is that it states the result in terms of percentage rather than through monetary amounts (variances in scale). Comparison through only percentage results while considering the overall purpose of maximization of shareholders’ wealth can be a misleading approach during evaluating investments. (Atrill/McLnaey) Then when assessing mutually exclusive projects IRR rule can lead to an incorrect decision making, due to its reinvestment assumptions. The assumption of reinvestment of proceeds derived from the project supports the consideration of superiority of NPV over IRR.
According to the assumption if NPV is accepted then the cash flows derived from the project could be reinvested maximum as the cost of capital. But IRR assumes that all cash flows from the investment can be reinvested with the same IRR of the original project. Theory states that, a firm should take all projects which a return that exceeds the cost of capital but any other available funds could only be reinvested at the cost of capital and this assumption is consistent with NPV approach mentioned. drury) Major shortcomings of payback period can be concluded as 1) ignorance of cash flows beyond the payback period, 2) its failure to contribute to the owners’ wealth while it underlines taking projects that recover original costs most quickly and 3) its ignorance of time factor. For instance: If one borrows a student loan which has a payback period of 13 years, the full amount of the loan is due 13 years after the first payment, which occurs on an agreed-upon date. Over the course of the payback period, a borrower must either pay back the loan with his own finance take out a different loan to pay off the first.
As a conclusion I would like to stress that, during project evaluation two essential facts should be considered thorugh a well-grounded method of assessment. The first one is the rule “cash is the king” (cash can be invested anyway or another when it’s available) and the second one is the time value of money. This suports the fact that the money is to be invested immediately where it could result in capital gain and. Then since purchasing power diminishes year by year due, the most correct method of the capital budgeting is the one that combines both the risk,inflation and time factors such as NPV. (management acc for business decisions)
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