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The theoretical rationale for the NPV approach to investment appraisal - Essay Example
Finance & Accounting
Pages 10 (2510 words)
Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
Net Present Value Method
383). It is originally attributed to Irving Fisher in his 1930 book, The Theory of Interest. The most common application of the Fisher model of NPV is in deriving the value of the net contribution of a potential investment to shareholder value, or for budgeting purposes, when deciding among alternative projects when available capital is limited and may not be sufficient to finance all the projects. In fact, the NPV is a valuation method that may be used to decide situations for which a stream of future returns and future payments may be estimated.
The power and allure of the NPV is that it serves so well the role of financial markets that allows individuals and corporations to transfer money between dates (MacMinn, 2005:1). By creating a rationale valuation tool linking money in two different points in time, it becomes possible for the individual to “save by transferring dollars from the present to the future,” while the corporation may “invest and finance the investment by transferring dollars from the future to the present” (p.l-2). However, for the model to work requires knowledge of the cost of capital from which the discount rate is derived.
The NPV is derived by discounting all future cash inflows and outflows to the present. ...
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