A thorough analysis of what a business venture or investment will impart the company is one of the most important steps in sustaining profitability, maximizing company's resources, and accepting or rejecting prospective projects (Brealey et al, 2005).
The payback period is regarded and widely used because of its relative simplicity. Managers prefer to use it because it is generally easy to memorize and to use (Peterson and Fabozzi, 2002). However, this technique disregards the additional cash flow which can be recouped from the project as it only focuses on the time when the whole investment will be recovered (Higgins 2005). Since the concern of the payback period is when, it does not really tell a business organization whether an investment is worth pursuing or not. Also, because of the relative view of managers on when the amount of investment should be recovered, there is no definite conclusion if project should be accepted or not.
The following tables show the computation of the Net Present Value (NPVs) of the two projects under consideration. Using the expect annual cash flow, the computed NPV for project 1 is $31,740 while it is $34,200 for project 2.
If NPV is only the man consideration of the business organization in capital budgeting decision, it is apparent that both of the projects should be accepted. It should be noted that using the NPV method, any project which does not yield zero NPV should be considered and pursued by the business organization. Thus, in the case of the evaluated projects above, both should be considered as they both yield positive values of NPV.
4. Explain the logic behind the NPV approach.
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows (Keown, et al, 2005). The Net Present Value (NPV) analysis is very much different from other capital budgeting techniques like payback period because it takes into account the time value of money. In the computation for total cash flow, it also takes into account the total cash flow from the investment including the depreciation and the tax shield resulting from it. Starting from the expected annual cash flows from the prospective project, managers should assign a specific required rate of return, that is, the rate of return that the companies want to generate from the investment. This is often indicated as an interest rate. For example, if the company's rate of return is 12%, the company will only accept investments which will yield 12% or higher. This method recognizes that the value of dollar today is greater than its expected value tomorrow. Thus, all the cash flows are discounted according to the required rate of return. After generating the present value of all the expected future cash flows, it then takes the sum of these present values. Logically, if the sum is positive, it means that the project exceeds the required rate of return. In contrast, if the NPV is negative then the project fails to generate the set return. This technique is favored by more economists and managers because it is more realistic.
5. What would happen to NPV if the required rate