The concept of net present values can be used in this situation to advise Harriet on the most appropriate action to take. Harriet has been presented two options to pay off the cost of TV i.e. either to pay in the lump sum 899 today or pay 50 in the beginning and 40 for the next 24 months…
The most suitable payment option of the two can be chosen with the help of present value concept. Harriet should choose the option which provides the lowest cost to be paid for the purchase of TV. The first option involving a complete payment of 899 today is to be compared with the second option suggesting payment of 50 in the beginning with 40 to be paid every month for the next 2 years. The present value of 899 to be paid today is simply 899. However, the present value of 50 today + 40 monthly for 24 months needs to be calculated. For this purpose the values of monthly payment needs to be discounted back at the rate of return Harriet expects to earn on an alternative investment. This would provide the present value of that series of payment that the purchase of TV requires. Because of the fact that there is equal monthly outflow, the NPV can be calculated with the help of the following formula:
The above calculation suggest that Harriet will actually be paying 981 as the total cost of purchasing the TV if she decides to accept the second option i.e. 50 plus equal monthly payment for the next 2 years. However, if Harriet decides to pay the cost of TV today, she would only be paying 899. This illustrate that Harriet will have to pay 80 in excess of the cost of TV if she agrees to pay in future instalments.
Hence, on the basis of the abov...
Hence, on the basis of the above calculations, it is advised that Harriet should pay the cost of TV today i.e. 899 because of the fact that she will have to bear higher cost if she pays in instalments.
Limitations of NPV as a Method of Investment Appraisal
Despite the fact that Net Present Value or NPV serves to be the most important of all the available investment appraisal techniques, there happen to be several limitations of this method. The first drawback of using NPV as investment appraisal is this method's reliance on discount rates which should represent the opportunity cost of capital. This opportunity cost of capital might be the cost of funds employed in the investment, rate of return on alternate investment and inflation etc. The determination of a correct discount rate is very important in the calculation of NPV as it is the rate which is used to discount back the value of future cash inflows to their present values. An inaccurate estimation of discount rate will lead to acceptance of a wrong project or rejection of a right one.
Another important point to be considered in calculation of NPV is that the method does not consider risk involved in accepting a project. It just evaluates a project on the basis of time value of money. However, there are several risks that are involved in starting a new project other than the time value of money such as business risk, financial risk, market risk, industry risk etc. A high NPV project might be having huge risk as compared to a low NPV project. The decision criteria made solely on the basis of NPV with no consideration for project risk can be misleading. Even if a risk premium is added to the discount rate, NPV will assume that the risk rate ...
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