The Net Present Value method
The Net Present Value method, which abides with the time value of money principle, is a capital expenditure appraisal method, which seeks the total future net cash inflow/outflow the project will provide in today’s terms. Indeed, the expected net cash inflow/outflow of every year is discounted with a cost of capital rate determined by the company. There is not standard cost of capital that can be used, because it is different for every organization and project undertaken. The main components of discounting are the inflation rate, the risk-free component, general risk premium and property-specific risk premium. These stem from the cost derived from the finance medium selected, risk of the project failing to provide the anticipated cash inflows and the rate of return attained from comparable capital projects. The factors mentioned above will differ between companies and projects, thus substantiating the point of no standard discount rate.
This method also uses the time value of money concept. Under this technique, the discounted cash flow principle is applied in a less practical way. The internal rate of return is determined in this method normally by trial and error. This is the point at which the projects will break-even leading to a zero net present value. A capital project is financially viable if the internal rate of return is greater than the discount factor applied for the project. In fact, the higher the internal rate of return the greater the financial feasibility of the project at hand, because the higher is the margin of safety of the project not incurring a loss.
As its name implies this is a modified capital expenditure appraisal technique of the method described in the previous section. The modification mainly stems from compounding all positive cash flows forward to end of the capital project duration. The figure attained by the modified internal rate of return method is the one that portrays the present value of all cash outflows together with the future value of all cash inflows.
The internal rate of return weakness that is mitigated by this method, which is also outlined in the next section, is the multiple root problem that is encountered when discounting cash outflows to the present date.
The adoption of discounting, which adheres with the time value of money principle, which takes into account important business and economic factors such as the inflation rate, the risk-free component, general risk premium and property-specific risk premium is considered both by the internal rate of return, modified internal rate of return technique and net present value method. Even though they are more complex in nature and require more technical calculations, these three methods provide valuable financial information of a much better quality due to such feature.
When the capital projects evaluated are not mutually exclusive and can be considered independently during the valuation, the net present value method and the internal rate of return approach will provide identical results, leading to the same decision. However, the scale of the project is properly considered by the former capital expenditure appraisal model, because it is an absolute measure of the project’s financial return. On the contrary, the internal rate of return system adopts a relative measure to the project’s size and cash flow timing in relation to initial capital expenditure. Therefore when projects are mutually exclusive and ranking is necessary in the business valuation, these two methods may provide dissimilar results. The net present value method provides financial information of greater quality in such instances because it directs towards the capital project that holds the highest increase in financial wealth for the organization. In addition, the ranking exercise is much easier to apply when the net present value method is adopted for mutually exclusive projects.
The internal rate of return model can also provide misleading information when cash flows are non-conventional in the capital project examined. In such cases, a nil or a vast number of internal rates of return may be derived, which would render the application of such method useless. This problem does not apply to the net present value method.
Even thought, the internal rate of return method had been improved by the adoption of the modified internal rate of return technique the net present value method is still the best method that an organization can adopt in order to value its capital projects. We ought to keep in mind that only one limitation is removed with the application of the modified internal rate of return method. In this section more were noted, that may provide inaccurate financial information leading to wrong decisions.
References:
- Brockington B. R. (1993). Financial Management. Sixth Edition. London: DP Publications.
- Drury C. (1996). Management and Cost Accounting. Fourth Edition. New York: International Thomson Business Press.
- Lucey T. (2003). Management Accounting. Fifth Edition. Great Britain: Biddles Limited.
- Randall H. (1999). A Level Accounting. Third Edition. Great Britain: Ashford Colour Press Ltd.
