Net present value (NPV)

Net present value (NPV) is a discounted technique, which considers the time value of money. NPV consider different period cash flow value differ in their values. So, estimated cash flow must be converted into present value. It can be defined as the difference between total present value and net cash outlay. It is determined as following.

Net present value (NPV) = Total present value – Net cash outlay

Calculation Of Net Present Value (NPV)

illustration,
Suppose,
The net investment = $ 50,000
Cash flow per year = $ 16,000
Period(No. of years)= 5 years
minimum required rate of return = 10%
Required:Net present value (NPV) 

Solution,
Net present value (NPV) = Total present value – Net investment
= (16000 x 3.972) – 50000 = $ 10,656

Decision Rules Of Net Present Value

1. If projects are independent
   Accept the project with positive NPV.
   Reject the project with negative NPV.
2. If projects are mutually exclusive
   Accept the project with high NPV.
   Reject other projects.

Advantages

1. NPV gives important to the time value of money.
2. In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.

3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm’s value.

Disadvantages

1. NPV is difficult to use.
2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of unequal life.