Theoretical Rationale for the Net Present Value - Research Paper Example

 Topic: Theoretical Rationale for the Net Present Value Introduction Net present value technique is one of the project appraisal techniques that are used by project managers or investors to determine whether the project is profitable. It indicate the value that a project or investment add to the firm. Net present value reflects the future value of money as compared to the present and it assumes that the cash flow that has been generated from investment are reinvested at the cost of capital. Therefore, it can be used to rank mutually exclusive projects based on the value of the net present value to be earned. The project with the highest net present value is ranked number one and is given priority over other projects. Scholars perceive net present value superior to the internal rate of return. They argue that net present value is real monetary value while internal rate of return is expressed as a percentage. Therefore, it is useful in measuring profitability of investment programmes. Most project managers prefer the use of net present values because of the many advantages it has as compared to the other project appraisal techniques. Application of the project appraisal techniques is key to undertake projects that add value to organizations, companies and institutions. Therefore, it is mandatory for all project managers to use project appraisal techniques to make investment decisions. Theoretical rational for NPV approach to investment appraisal Brigham and Ehrhardt (2008) assert that net present value (NPV) uses discounted cash inflow and cash out flow technique. Net present value predicts the equivalent of future money value as compared to today. To compute the net present values, it is mandatory that cash flow projections together with their respective cost of capital (discount rate) be determined. Net present values are important in determining the profitability of investments that organizations and companies undertake. The logic behind use of net present value in evaluating investment projects lies on the magnitude of a computed net present value of a particular project. If the net present value is greater than zero (NPV>0) the investment may be accepted. This is because it implies that the project will earn profit for the company or organization. If net present value is zero (NPV=0), the project or investment may be rejected or accepted at the same time. This is because the project will earn neither a profit nor a loss. If the present value is less than one (NPV0) can be undertaken. The Maxweb Corporation will be richer by £7177.909 by the end of the six months if the above project is implemented. Importance of net present value Net present value is preferred to other project appraisal techniques because of many reasons. It is popular among most project managers due to their flexibility and simplicity. The following are the strengths that have made the net present value appraisal technique most preferred. Firstly, net present value appraisal technique is easy to use. When cash flows, time frame (years or months) and discount rate are known, computation of net present value is straightforward and easily interpreted. Positive net present values implies that the project can be implemented, negative net present values implies that the project cannot be implemented while zero net present value imply that the project can either be implement or not depending on the prevailing circumstances. Secondly, net present value gives absolute value in monetary terms for projects or investments that company’s plan to undertake. Therefore, it is a best measure used by investment managers to determine profitability of future projects in their companies. Thirdly, net present values reflect actual investment scenarios in the rapidly changing business environment. Unlike other measures of project performances, net present value technique accommodates changing discount rates by incorporating changes as they occur. According to OECD (2008), project managers can use different discounting rates in evaluation of projects when the rate of interest changes from year to year. Fourthly, net present value assists project or investment managers to make decisions on the type of project to implement among mutually existing projects or investments. Fifthly, net present value incorporates time value of money. It predicts the future value of money as compared to the present. It considers factors such as inflation. Therefore, it is most appropriate appraisal method to use when appraising long-term projects of a firm or organization. Disadvantages of using the net present value techniques in appraising projects Net present value technique has it bad side as well. It fails to consider financial losses that may accrue to the project after initial investment. The losses may be in the form of clean up or restoration costs incurred long after the project is completed. The second disadvantage is that net present value technique uses compounding to calculate the net present values. High discount rates lead to lower net present values. Consequently, net present value technique may underestimate the values of the projects or investments. This is because computed net present values are very sensitive to the values of discount rates. The fifth problem of using net present value is that, net present values rely on forecasts of future cash inflows and cash out flows. The forecasts are uncertain and its validity depends more on the quality of the forecasts. Therefore, if cash flow and discount rate forecasts are not accurate net present values automatically are flawed. Sixthly, a person must calculate the discount rate used to calculate the net present values of the projects. The discount rate may not be available and it becomes extremely difficult and time consuming to compute it. Computing discount rate requires application of complicated arithmetic formula understood only by statisticians. The seventh reason is that net present value assumes risks as equal across all competing projects. However, different projects have different risks. As a result, they deserve different treatment in calculation of its future values. The eighth reason is that net present values compare only investment projects within an organization and not across organizations. This is because different organizations have different rate of return. In addition, it is not used to compare different types of investments that have different level of risks. Finally, net present values are only concerned with financial issues of the project or investment but they fail to address socio-political and environmental issues. A project that has high levels of profits does not necessarily mean that it is producing socially acceptable products or services. It may be polluting the environment as well. Comparing the net present values technique to internal rate of return and payback period Comparison of net present value and internal rate of return Internal Rate of Return is the annual percentage rate of return where the estimated cash inflow is equal to the estimated cash out flow (cash inflows= cash outflow) over a given life of the project. It can be defined also as the highest interest rate an investor can pay for the finance (funds) borrowed. Internal rate of return is calculated using polynomial equation. Internal rate of return may give more insights in situations where capital is constrained. However, internal rate of return does not consider cost of capital in a given project or investment. Therefore, it is not used to compare investment projects of different durations. Internal rate of return assumed that interim cash flows are reinvested at the same rate of return. Net present value and internal rate of return provides a basis of selecting investment projects in a given organization or company, and are used to determine and compare profitability of various investments or projects of organizations. The two project appraisals techniques offer an opportunity for project managers to choose which project earns the highest profits. Drury (2004) said that both net present value and Internal Rate of Return help in making decision on whether to accept or reject the project. They also suggest different rankings as to which project should be given priority. Both net present value and internal rate of return fail to address other project related issues such as environmental pollution and social negative impacts they may cause to the community in which they operate. Both Internal Rate of Return and net present values make use of discounted cash flows. Consequently, the two methods provide financial management insight and can be used to complement each other. Contrast between net present value and internal rate of return Internal rate of return is expressed as a percentage while net present values are expressed in absolute monetary terms. Internal rate of return can be used to compare different types of investment like bonds and ordinary shares. It is also useful to compare financial performances of different firms of either equal or different sizes. Net present values are use to compare similar projects within an organization. Net present values establishes whether the difference between cash inflow and cash out flows is positive at the current cost of capital. On the contrary, internal rate of return identify whether the internal rate of return is greater than the cost of capital. It proposes implementations of projects that higher internal rate of return than the cost of capital. Scholars believe that Net present value is theoretically superior to the internal Rate of Return. To illustrate further differences, the following two examples are used. There are circumstances when net present value and internal rate of return conflict. In such a case, net present value take precedence. The following examples illustrate the reason of superiority of net present value. For example, Maxweb Corporation has two projects; The cost of capital is 8%. Project A. The initial investment in year 1 is £1000. Cash inflows will be realized as follows year 3 will be £300, year 4 will be £600 and year 5 will be £900. Project B. The initial investment is £1000. The inflows in year 1 will be £320, year 2 will be £ 320, year 3 will be $320, year 4 will be £ 320 and year 5 will be £320 Figure 2; Project A and B cash flows Project A Project B Year (t) Cash out flows Cash inflows Cash out flows Cash inflows t0 £1000 £0 £1000 £320 t1 £0 £0 £0 £320 t2 £0 £0 £0 £320 t3 £0 £300 £0 £320 t4 £0 £600 £0 £320 t5 £0 £900 £0 £320 The internal rate of return of project A= 14.668% and project B= 18.03%. Internal rate of return was calculated using trial and error method. Both projects qualify for consideration because the internal rate of return of both projects is greater than 8%. However, Maxweb Corporation will choose project B because the internal rate of return is higher. Figure 3; Net present value computation for Project A Year (t) Cash out flows Cash inflows Net cash flow (1+r)t  NPV = Rt/((1+r) t)  Net present value t0 £1000 £0 £-1000 (1.08)0 1 £-1000 t1 £0 £0 £0 (1.08)1 1.08 £0 t2 £0 £0 £0 (1.08)2 1.1664 £0 t3 £0 £300 £300 (1.08)3 1.259712 £238.1497 t4 £0 £600 £600 (1.08)4 1.360489 £441.0179 t5 £0 £900 £900 (1.08)5 1.469328 £612.5249  Net present value £291.6925 Figure 4; Net present value computation for Project B Year (t) Cash out flows Cash inflows Net cash flow (1+r)t  NPV = Rt/((1+r) t)  Net present value t0 £1000 £0 £-1000 (1.08)0 1 £-1000 t1 £0 £320 £320 (1.08)1 1.08 £296.2963 t2 £0 £320 £320 (1.08)2 1.1664 £274.3484 t3 £0 £320 £320 (1.08)3 1.259712 £254.0263 t4 £0 £320 £320 (1.08)4 1.360489 £235.2095 t5 £0 £320 £320 (1.08)5 1.469328 £217.7866  Net present value £277.6672 Figure 4; Comparison of project A and B Project Internal rate of return Net Present Value Project A 14.668% £291.6925 Project B 18.03% £277.6672 According to the theory net present value, projects with net present value greater than zero (NPV>0) is considered for implementation. However if the projects are mutually exclusive, then project A will be considered because it has higher level of net present value. The two appraisal techniques are conflicting on the choice of project to be undertaken. Internal rate of return method prefer project B to project A while net present value method prefer project A to Project B. However, companies are concerned with the amount of value created. The higher the value generated by a project, the best the project. Therefore, project A will be considered for implementation by Maxweb Corporation because of the high value it will generate as compared to project B. Internal rate of Return do not guarantee ranking of mutually exclusive projects. This is because the internal rate of return can mislead during selection of projects. Payback period Companies and organizations face investment challenges on what investment decision to make. This is because the decisions on what to invest demand commitment of funds to purchase land, machinery, plants and even buildings. The companies and organizations anticipate earning greater income than the funds committed. Pay back period is the period of time cash inflows take to equal cash outflows. Firms usually accept projects that have the shortest pay back period because they consider it as a good investment. For example, Maxweb Corporation plans to invest their funds in developing office management application soft ware. Soft ware development will cost the company £350,000. The project expects to generate £70,000 net inflows annually. The formula for computing the pay back period is as follows: The pay back period= Initial payment ÷ net cash inflow = £350,000 ÷ £70,000 = 5 years Therefore, it takes five years for Maxweb Corporation to recoup its initial investments of £350,000. Comparison of payback period and Net Present Value techniques Pay back period and net present value technique play enhance decision-making on what to invest. Both project appraisal techniques do not consider environmental and social issue of projects as well. Furthermore, they do not consider the cash flows that accrue to the projects long after the project is completed. The two projects appraisal techniques are very different in some aspects. For example, net present values are in absolute monetary values while pay back period are presented in the number of years. Payback period ignores the time value of money. In addition, it does not take into account the money earned after the payback period. The two techniques can be used to complement each other in one way or the other. Advantages and disadvantages of using payback period project appraisal technique Computing pay back period is straightforward and easily understood. Secondly, it is an appropriate project appraisal method for projects or investments prone to rapid technological changes. This enables an organization or company recoup investment before the project becomes obsolete. Thirdly, it is appropriate in investment climates that have higher rate of cost of capital. This enables companies or organizations to recoup their investment and pay off their debts within a short time. Payback period technique has the negative side also. Firstly, the technique lacks objectivity. There is no optimal payback period. The second problem is that it does not consider cash flows beyond the payment period. Thirdly, it does not consider the profitability of the project. It is only concern with the cash flows. Fourthly, it does not consider time value of money. Conclusion Net present value is an appraisal tool and is used for capital budgeting. It is instrumental in helping the project managers to make decisions on what to invest in or undertake. Net present value reflects the value of business more accurately as compared to the payback period and internal rate of return methods. There are Despite numerous advantages accruing to the use of the net present value appraisal technique, it is worth noting that it should no be used in isolation. Instead, they should be used concurrently with other project appraisal techniques such as the pay back period and internal rate of return appraisal technique. It is important to note that, though scholars argue that net present value technique is superior to the other project appraisal techniques, none is superior over the other. Different project appraisal techniques are relevant to different unique situations. Therefore, all techniques must be treated as compliments of each other. References Brigham, E. and Ehrhardt, M. (2008) Financial management: theory and practice. 12th Edition. USA: Cengage Learning. Drury, C. (2004), Management and cost accounting. 6thEdition. London: Cengage Learning EMEA. Macdonald, M. (2006), Excel 2007: The Missing Manual 2ndedition. USA: O'Reilly Media, Inc. OECD (2008) Education at a Glance 2009: OECD Indicators. France: OECD Publishing Ross, S. (1995) Uses, abuses, and alternatives to the net-present-value rule: Financial Management. New York: MacMillan Publishing Company Shimko, D. (2001) NPV No More: RPV for Risk-Based Valuation. London: Risk Capital Management Partners. Read More