Define NPV in discounted cash flow technique in capital budgeting.

Finance ManagementAccountingAcademic Content

Net present value (NPV) is the value of all future cash flows over the entire life of an investment discounted to the present. It is one of the most reliable techniques used in capital budgeting, because it is based on discounted cash flow approach. It may be positive, zero or negative.

  • Present value of cash inflow > present value of cash outflow (NPV is positive and project is acceptable).

  • Present value of cash inflow = present value of cash outflow (NPV is zero and project is acceptable).

  • Present value of cash inflow < present value of cash outflow (NPV is negative and project is not acceptable).

Advantages

  • Time value of money is taken into consideration.
  • It takes into consideration all the inflow, outflows and risk involved.
  • Value of investment.

Disadvantages

  • Different projects are not comparable.

  • Multiple assumptions.

  • Rate of return has to be determined, if higher/lower rate of return is assumed, it will show false profitability of the project and hence, result in wrong decision making.

Formula

$NPV=\sum_{I=1}^n\frac{R_N}{(1+l)^n}-X$

X = initial investment

R = net cash flow

N= year of net cash flow

I = discount rate

Example

Initial investment = 1000000, discount rate = 9%

YearFlowPresent valueComputation
0(1000000)(1000000)
110000091743100000/1.09
2250000210419250000/(1.09)^2
3350000270264350000/(1.09)^3
4265000187732265000/(1.09)^4
541500026721415000/(1.09)^5

NPV = 1000000 – (91743+210419+270264+187732+26721) => 29879 (POSITIVE)

raja
Published on 11-Aug-2020 15:01:33
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