Net Present Value by James Hutchinson - Article Example

Article USE OF NET PRESENT VALUE ANALYSIS BY ELECTRIC COOPERATIVES Published: 2000 http www.entrepreneur.com/tradejournals/article/66172514.html The article states that NPV is a good measure for both profit and not-for-profit business organizations for capital budgeting and investment appraisal related issues. As the title of the article suggests, this article talks about how NPV has been adopted by Electric COOPERATIVES. The article stated that there are two problems in NPV system as result of which this method is not very common among COOPERATIVE firms. If these two problems are solved then only we can expect full-fledged use of this method by the firm's which are meant to be not for profit organizations. The first of these two problems are that NPV is used to assist managers in maximizing the wealth of shareholders, but in cooperatives there is no need to maximize the wealth of shareholders but give service to the society at the lowest possible cost. However, the supporters of NPV claim that all the principle of social well being and correlated with wealth maximization and NPV, therefore, can help even not for profit organizations. Similarly, the second problem states that it is very difficult to calculate the cost of capital of cooperative to determine the value of NPV. Here again, it is suggested that cooperative can calculate cost of capital just like the investor-owned businesses. Article 2: The Lottery and Net Present Value Is it better to Take Cash or Payments James Hutchinson, 2008 http://consumereducation.suite101.com/article.cfm/net_present_value_and_the_lottery The article talks about the patterns of payment if a person wins a lottery. A person has choice either to take all his winning in lump-sum or to receive the payment in installments. The article distinguishes that the amount stated as winning prize is the total money in installments whereas the lump-sum prize is usually lower than the sum of installment payments. The author states that lump-sum amount is calculated by using Net Present Value or NPV. Many people want to take the money home today than to wait for the installment payments. However, their decision might not be the same if the interest rate given by lottery firm is greater than at which we on our own can invest. For e.g. If we can invest the money at 5%, and lottery firm is giving us 7% return, in this case many people would prefer taking the money in installments as lump-sum payments discounted at 7% will be a lot lower than discounted at 5% and hence people would lose out by taking the cash now rather than waiting for the installment payments. Article 3: Calculating stock or investment returns: the difference between ROI and IRR http://mindyourdecisions.com/blog/2008/11/13/calculating-the-rate-of-return-on-investments-roi-versus-irr/ The article talks about how Return on Investment is Different from internal rate of return of the investment made in stock or shares of a particular company. The article states that ROI is a simpler version of IRR. ROI simply states the increase or decrease in the investment made, whereas IRR takes into account various other factors such as cost of this investment if it is borrowed from external factors. IRR is much more realistic as result and many companies have started using this method for appraising their investments made in the stock markets. According to the author, the realistic beauty of IRR lies in the fact that it includes factors like taxes and dividends which are essential in determining the correct rate of return on any investments. In the end of the article, the author has accepted the claims of people who are against IRR that it being a much complex method cannot be solved without having specialist financial calculators or spreadsheets. Advantages and Disadvantage of NPV: NPV is an important method in assessing or appraising the investment made on a project. NPV lower than 0 means that the project is not feasible, whereas an NPV of greater than or equal to zero means that the project is feasible. There certain advantage and disadvantage of the method that we are going to discuss in the next few paragraphs. ADVANTAGES: NPV takes into account the time value of money of all the cash flows. Under financial management, time value of money is considered the vital aspect of any financing decision and it is NPV's credit that it does not ignore such important factor of the financial management. Another merit of the project lies in the fact that NPV is not limited to certain periods like Payback period is. Instead NPV can be used to appraise the project throughout its entire life. This means that NPV is a better method of Capital Budgeting than Payback Period or Discounted Payback Period. NPV allow us to evaluate any type of project with great success. The project does not only have to be revenue generating and instead it can be cost saving, project with no upfront costs and projects with costs spread over a diversified number of periods. NPV also takes merits over other method in the fact that NPV is the most complete method as it does not only take into account time value of money, but it also takes into account the cost of investment, project's entire life and initial amount invested in the project. DISADVANTAGE OF NPV: It is very difficult to identify the correct discount rate as in real world there are various fluctuations in the interest and inflation rate and because of the fact that data gets outdated really quickly. NPV requires decision criteria to be made even before the investment has been undertaken and this makes it difficult for financial managers, who have to do a lot of estimation in order to arrive at the correct figures. IRR Internal Rate of Return is just another method of investment appraisal that is closely related to NPV and like NPV have certain merits and disadvantages. ADVANTAGES: Like NPV, IRR also takes into account the time value of money and the total life of the investment unlike other methods like payback period and discounted payback period The results of IRR can be very strange for non-accounting people. For example, suppose that the firm's cost of capital is 11%, whereas IRR is 40%. It is very difficult for non-accounting people to understand as it could mean two or three different things for them. In reality it means that the firm has chance to reinvest their cashflows at 40%. This is susceptible because it means that only a fool is letting us use his money at 11%, when he can earn 40% on his money. This is unrealistic and false. References: Article 1. Retrieved on 5 Jan 2010. http://www.entrepreneur.com/tradejournals/article/66172514.html Article 2. Retrieved on 5 Jan 2010. http://consumereducation.suite101.com/article.cfm/net_present_value_and_the_lottery Article 3. Retrieved on 6 Jan 2010 http://mindyourdecisions.com/blog/2008/11/13/calculating-the-rate-of-return-on-investments-roi-versus-irr/ Wachowicz and Horne.(2004). Fundamentals of Financial Management. Pearson Harold Randall. (1996). Accounting. Letts Educational Read More