The money you have todayis always an asset and it worth’s more than what it will be in the future, the reasonbeing the future is unpredictable to us (Gallo, 2014).Maybe there is inflation or a sudden economic down turn. Secondly, the cash oran asset you are holding today can be invested and you can earn more.
So, toestimate the financial worth of what you are holding today and what it will bein the future, NPV is used (Gallo, 2014).According to Hillier,Ross, Westerfield, Jaffe & Jordan (2010) net present value is the methodthat is most frequently used in business today that has been used by investorsto make investment decisions. Many decision-makers have termed it as mostcorrect and accurate than payback and discounted payback period.
Net presentvalue is the technique used to assess physical asset investment projects whichtake into account the projects which could be lucrative for the businesses. Thetechnique is especially used for the projects that are large in value, quantityand money. As far as the discounted cash flow approach is concerned, it is anelement of net present value. The only difference between net present value anddiscounted cash flow model is that, the net present value deducts the initialinvestment after getting the present value of cash flows. (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2010).Net present value is alsouseful from an investor point of view and can help a lot while deciding on whetherto invest in a company or not (Linn, 2018).According to him, when an investor is planning for investing in a company, theyalways try to invest in such a stock which will give them the highest returnand there is no shortcut to that. Net present value can be used to evaluatewhether it will be a good investment or not.
For example, a stock worth $1000today and inflation is 2 % per year, meaning after one year you can only buystuff valuing $980. Expected profit is 3%, so the net present value today is$1030 divided by one plus inflation rate, you will get $1009.8 that means apositive net present value. If you get a positive or zero net present value,that means you are good to go and can invest but when it comes to investing instocks, you need to go a bit further.
The next step is to look for sharesavailable in that particular company and then you divide the net present valuewith available shares to get net present value per share. Consider a companywith the net present value of $20,000 has 2,000 shares. That means you have anet present value of $10 per share. The next step is to look for the marketprice of that particular share, if that is $4, you can invest but if it’s $14,the share is already overpriced. On the other hand, this method also has somelimitations i.e. you always don’t know the growing percentage of the companyand deciding on discount factor is critical because if a company decides toinvest in a new project or introducing a new product line and all theseinvestment decisions has risk aspect also (Linn, 2018).
In today’s competitiveworld, the key to success is always growing. From a company’s point of view, italso includes investment in different projects, and to decide whether to investor not a large number of companies use net present value approach (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2010).Net present value employs discounted cash flow technique in the analysis whichmakes the net present value method most widely used as it takes into accountboth risk and cash flows. The method assesses estimated cash flows that wouldbe extracted from the project by discounting them to the current time periodmaking use of time span of the project and firm’s weighted average cost of capital.The result is evaluated on the basis of being positive or negative.
In case ofthe positive figure, the project would be financially feasible and companyshould carry on with the project and if the result is negative, the projectshould be out rightly rejected without weighing any other factor (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2010).(Cheng, Kite, & Radtke, 1994) narrated that beforeapplying the net present value method it’s important to figure out whether theproject is mutually exclusive or independent project. Independent projects arethose not having any link with the cash flow of other projects.
However,mutually exclusive projects are entirely different. The mutually exclusiveprojects mean that there are two ways of accomplishing the same result but onlyone could be opted as choosing one would make it impossible to choose theother. When investor evaluates two different projects based on the NPVcriterion, it’s crucial to find out the type of project in order to make acceptor reject decision. In case of independent projects, the project with any valuegreater than zero should be chosen. While in case of a mutually exclusiveproject, if NPV of one project is greater than NPV of the other project, theproject with the highest NPV should be accepted.
If both projects are yieldingnegative NPV, both projects should be rejected