Method Of The Net Present Value Finance Essay
Investment projects are considered to be investment shares that are aimed at achieving a profitable return, and obtaining positive results in a pre-planned schedule. There are several methods to assess the attractiveness of the investment project and a few basic criteria for the selection of a project. An important principle lies in the heart of each method, according to which the company must make a profit as a result of the project. Meanwhile, the different financial indicators characterize the project from different sides in accordance with the interests of the various stakeholders related to the company (such as lenders, investors, management).
Thus, the criteria used in the analysis of investment activity (integral indicators) are as follows:
Net Present Value (NPV);
Internal Rate of Return (IRR);
Profitability Index (PI);
Payback Period (РР).
Therefore, this paper presents the information on the methods of evaluating capital projects, explores the effect of a volume increase in sales, a price increase in sales, and discusses a cost decrease on the net operating income.
The concept of net present value (NPV) is widely used in the investment analysis for the evaluation of investment. Generally speaking, the net present value (NPV) is a sum of current values of all the predicted cash flows. “Therefore, the net present value of an income stream is the sum of the present values of the individual amounts in the income stream” (Baker, 2000, para. 13).
The method of the net present value (NPV) is as follows:
It is important to determine the present value of costs (Io), i.e. how much investments are needed to book for the project;
It is necessary to calculate the present value of future cash flows from the project;
The present value of investment costs (Io) should be compared with the present value of income (PV). The difference between them is the net present value of income (NPV): NPV = PV – Io.
NPV shows the net gains or net losses of the investor from putting money into the project than keeping money in the bank. If NPV > 0, then we can assume that the investment will increase the wealth of the company and in this case the investment should be implemented. When NPV < 0, it means that the proceeds of the proposed investment is not high enough to compensate for the risk inherent in the given project and thus the investment proposal should be rejected.
The net present value (NPV) is one of the key indicators used in the investment analysis, but it has several drawbacks and cannot be the only means of assessing the investment. NPV determines the absolute value of the return on investment, and, most of all, the more investment, the higher and the net present value. Hence, a comparison of several different sizes of investment by this index is not possible. In addition, NPV does not specify the period over which the investment will be paid off.
IRR (Internal Rate of Return) determines the maximum cost of capital employed at which the investment project remains profitable. “IRR is a true indication of a project’s annual return on investment only when the project generates no interim cash flows — or when those interim cash flows really can be invested at the actual IRR” (McKinsey & Co, 2004, para. 6). Thus, the internal rate of return determines the maximum acceptable discount rate at which you can invest without any loss to the owner.
Comparing the two methods of evaluating capital projects: NPV and IRR, it is possible to say that the calculation of the internal rate of return and the net present value are based on the same methodological assumptions. However, in this case it is critical to set specific a task in order to prescribe the level of return on investment, which will ensure equality of discounted values of income and expenses over the life cycle of investments. Based on the definition of the internal rate of return (IRR), we can say that IRR corresponds to the discounted cash flow rate at which NPV = 0.
Additionally, the efficiency of investment project can be estimated by using profitability index (PI).
Generally speaking, profitability index is a criterion of the project’s assessment defined as a ratio of the present value associated with its implementation of the future net cash flows to the present value of the initial investment. Thus, PI is a consequence of the method of net present value. It is calculated as the net present value of cash flows (P) to the net present value of cash outflows (IC) (including the initial investment): PI = Y k (Pk / (1 r) k / IC. It is obvious if PI> 1, then the project should be taken into consideration. If PI <1, then the project should be rejected. When PI = 1, then the project is considered to be neither profitable nor unprofitable. Owing to this fact, PI is very convenient when choosing one project from a number of alternative ones, which have approximately the same net present value, but different amounts of investment required. In this case, it is essential to choose a project that offers the greater cost efficiency. In contract to NPV, profitability index is a relative measure. It characterizes the level of income per unit of cost, that is, cost efficiency – the higher the value of this index, the higher the return of each dollar invested in the project.
Payback method is a specific period of time needed to ensure the sufficient receipts to offset investment costs. This “method is still quite often used as the single or at least primary method for investment evaluations” (Yard, 2000, p. 156). Hence, payback method along with the net present value (NPV) and the internal rate of return (IRR) is used as a tool for evaluating investments. Payback method is almost never used by itself, but only as a complement to other indicators, such as, for example, the net present value or IRR.
In order to remain competitive in today’s tough economy, every organization should strive to increase sales volume. The companies have to bear high costs to attract customers: hold stocks, develop a system of discounts, offer bonuses, and more. In addition, the effective work of sales is one of the most important components of financial health of the company. Increasing sales volume greatly affects the company and makes it profitable and competitive at the international global market. In turn, raising the prices may increase the company’s sales and have a positive effect on the sales volume of some goods or services (Symes, n.d.).
Talking about a cost decrease on the net operating income, it is possible to say that it is calculated by subtracting from the value of the annual gross revenue of all operating expenses. However, the interest expenses, amortization of tangible assets and amortization of intangible assets, and the tax liability on income are not deductible.
In conclusion, it is possible to say that the methods of evaluating capital projects are critical to the identification of investment opportunities of the company. All the above-mentioned methods are based on the evaluation and comparison of the projected investments and future cash flows arising from investments.
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