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Explaining the theoretical rationale for the NPV ( net present value ) approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
NPV definitions
NPV can be defined as the present value of future cash flows from an investment after netting out initial expenditures.
NPV is the residual profit or loss after all expenses have been covered in present value terms.
The one-period case
The NPV of an investment is the present value of the expected cash flows, less the cost of the investment. The formula for NPV can be written as:
How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects of this risk level.
The third step is so find the present value of the cash flows and subtract the initial investment.
NPV=total PV of future CFЎЇs + Initial investment
Estimating NPV
1 estimate future cash flows. How much and when.
2 estimate discount rate
3 estimate initial costs
If the NPV is positive, accept the project
A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet