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Advantages And Disadvantages Of Using Net Present Value To Evaluate Potential Investments

Referencing Styles : MLA | Pages : 1
  • University: Columbia University
  • Country: US

There is specific advantage and disadvantage of using the net present value for evaluating the potential of an investment. Net present value is one of the major investment appraisal technique, which allows the organization for detecting the accurate financial conditions of a particular project. The investment appraisal technique analysis always allows the management for understanding the relevant significance of the project and the levels of returns that might be generated from a project. The investment appraisal technique not only use net present values but internal rate of return, payback period and profitability index, which can help in determining the correct valuation of the project. The net present value is mainly used for detecting the time vale of money, which helps in determining the projects integrity. There are certain advantages and disadvantages of net present values, which has direct impact on the valuation of the project.

Advantages of Net Present Value:

Assumptions of Reinvestment: The net present value mainly allows the organization for detecting the assumptions on reinvestment, which can allow the organization for understanding the income that might be conducted for generating high level of income from investment. The time value off money is mainly analyzed for detecting the benefits that might be generated from the relevant project after accounting for the discount rate and other investment opportunities. The net present value calculation project all the relevant information about the project by analyzing the future cash flows and detecting the present value of the benefits.

Accepts Conventional Cash Flow Patterns: The net present value calculation accepts the overall conventional cash flow patterns that is anticipated by the proposed project. This calculation would eventually help in understanding the financial performance and the benefits that might be conducted for generating high level of income from investment. The net present value calculation accommodates the conventional cash flows such as any negative cash flow after the initial investment. This method is mainly used for discounting the cashflow and detecting its time value of money, which can help in detecting the future performance of the project.

Consideration of all Cash Flows: The net present value calculation accommodates and considers all the relevant cash flows after that strengths until the life of the project. The net present value cashflow does not work as payback period calculations, which only accommodates the cash flow until the values are derived and does not accommodate all the cashflows attained by the project. Therefore, net present value considers all the cash flows that is defied by the project for analyzing the benefits that would be generated from the project.

Good Measurement of Profitability: The calculation of net present value also allows the organization for evaluating more than one project, as it is considered a good measure for analyzing the profitability of the project. The net present value is also considered, as the overall measure of profitability, which allows the organization for detecting the project that provides the highest level of income from operations. The net present value calculation supports the managers decision for detecting the appropriate investment options, which can help in generating high level of income from investments.

Factors Risks: The net present value method mainly uses the discount rate for detecting the risk of the undertaking the project. The major risk that affects the project is business risk, financial risk, and operating risk for detecting the relevant factors hindering the operations of the method. The relevant factors are mainly considered by the organization for understanding the financial performance of the project. Therefore, the risk factors allow the managers to understand the critically of the project and reduce any kind of limitations in the valuation.

Disadvantages of Net Present Value:

Estimation of opportunity cost: The net present value calculation only estimates the opportunity cost during the initial outlay, as it is fairly difficult for determining the opportunity cost during the project. Therefore, the accommodation of the opportunity cost during the initial outlay will distort the results that would be achieved by the project.

Ignoring Sunk Cost: The net present value calculation directly ignores the sunk cost, which is necessary for understanding the total expenses that has been incurred by the company for commencing the project. The net present value method ignores the research and development cost that is incurred by the project, which is an integral part of staring the project.

Difficulty in determining the required rate of return: One of the major difficulties that is faced by the organization is the determination of the required rate of return, which is difficult for detecting the financial perspective of the project. The firm needs to understand whether WACC or the cost of capital needs to be used for calculation of net present value, as wrong valuation will directly have negative impact on the results and hamper the decision making process of the managers.

Optimistic projections: One of the major limitations of the net present value calculation is the optimistic projections that is required by the method. Sometimes managers are too optimistic about the projects, which leads to exaggerated income projections. The exaggeration about the overall cash inflows would nullify the results that would be presented by the net present value method. Thus, the high projections of the cash inflows would not allow the mangers to detect the correct valuation of the future performance of the project.

Difference in size of the project: The size of the project is also a major concern for the managers, as net present value calculation does not detect the financial viability of the project that has different useful life. The managers are not able to understand the financial performance of the project with different project life, as NPV provide higher valuation for the project with higher income. Hence, the net present value calculation is effective for detecting the financial viability of the project that have same useful life, as the method lose its significance when evaluating the project with alternative useful life.

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