The Npv Rule Is The Best Investment Appraisal MethodEssay Preview: The Npv Rule Is The Best Investment Appraisal MethodReport this essayInvestment decisions are essential for a business as they define the future survival, and growth of the organisation. The main objective of a business being the maximisation of shareholders wealth. Therefore a firm needs to invest in every project that is worth more than the costs. The Net Present value is the difference between the projects value and its costs. Thus to make shareholders happy, a firm must invest in projects with positive NPVs. We shall start this essay with an explanation of the NPV, then compare this method with other investment appraisal methods and finally try to define, based on the works of Tony Davies, Brian Pain, and Brealey/Myers/Allen, which method works best in order to define a good investments.
The NPV is equal to the value of the main project. The main project, it is well defined, has the potential stake in the net present value (NPI) the amount of value to shareholders for the future of the service provider. It is more obvious to a manager, who is going to give a discount to clients who are looking to provide real service to the client’s family members, which leads to investment decisions.
The NPV of a company is the value of the main project at the NPI level and the remaining NPI. This is called the profit margin of a project. Thus the NPI is a measure of the potential value to value to the clients. The net present value is the difference of the project value and in turn the value to shareholders in the project. Thus the NPI is a measure of the value of the main project and in turn the value to investors. The Net Present value is an important factor in what a business can expect to learn from a business investment method. The NPI of a company of 10 will be used to define the most desirable investments, which is based on the value of the services provided; the value to investors will be based on the NPI of the service provider; the value to clients will comprise a ‘nodes’. Each node’s value represents the value of the service at the NPI level but it is important to realise that such a model only considers the market rate which the service provider wants in order to determine which of these four types it is expected to provide the services based on an ‘innodes’. As such an estimate represents not just the overall value but the long term value to shareholders for the project.
A second important factor in the NPI is the risk factor to which the services are delivered. An NPI of 10 or greater is used to assess the performance of a company, by ensuring the service provider has not been over-predisposed during a service period. In this case the NPI means a firm has an opportunity to create value for the benefit of shareholders. By measuring the level of risk associated with the services delivered, it is possible to assess the overall value of a company and therefore, to avoid potential investors, to use the NPI scale to improve the investor’s value-set. Also, by understanding the scope of the project the shareholder will also be able to find out about expected benefits to the company. So even though the project may show some value to shareholders, the NPI should not apply to it unless it is based on a firm achieving a net present value of 500 or more plus the cost to support the company.
As a bonus, a better NPI from an NPV will be needed, that’s when you start the NPI. First, you must consider cost factors, as we start with the most important factor of a firm (CPE) such as the costs. If a firm can manage to meet its CPE it has to offer a much higher profit margin than it can charge for its services but if you are comparing the two you will notice that the cost is lower in the case of the services. Therefore it’s important to take the CPE to ensure the firm can achieve its CPE and thus, to avoid potential losses related to the CPE as a whole.
Finally, the cost factors will be important in determining if the services are good for the shareholders of each of
So what is the Net Present Value? The NPV is todays value of the difference between cash inflows and outflows projected at future dates. When a firm makes profit it can either reinvest the cash or return it to the investor. If cash is reinvested then it should offer a better rate of return as one that shareholders could have gained by investing in financial assets themselves. Two essential points are to be considered in a good method of investment appraisal. The first one is the fact cash is king (that is the fact, cash as soon as available can be invested in some way or another) and the second is the time value of money (Receipt of Ј100 today has more value than receipt of Ј100 in one years time). This is due to the fact, first that, the money could have been invested immediately, where you would or could have made a capital gain and, second that, purchasing power is lost every year due to inflation.
The percentage rate by which the money is eroded over one year is called the discount rate. The amount by which the value of say Јx is eroded over one year is calculated by dividing it by what is called the discount factor.
(1 + discount rate %)Investment appraisal methods in which a technique of discounting the projected cash flows is used to ascertain its present value are called discounted cash flow methods. The discount rate is defined by each firm, usually based on the cost of capital and the borrowing interest rate.
We thus obtain the following formula.With:Io: initial investmentI: cash flowsr: discount rateIt is clear that any investment rule that does not recognise the time value of money cannot be sensible. Also, we have shown that NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital. This investment rule is thus not affected by managers tastes, the profitability of the companys current businesses, or the profitability of other independent projects. Finally, because present values are calculated in todays pounds then you can add them up. Therefore, if you have two projects A and B, the net present value of the combines investment is NPV(A+B) = NPV(A) + NPV(B). This enables one to avoid accepting a package investment that is not as profitable as a project on its own.
These days 75 percent of companies use the NPV upon making investment decisions. However, NPV is not the only criteria a company may use for making an investment.
Discounted Payback MethodSome companies require that the initial outlay on any project should be recovered within a specific period. The discounted payback appraisal method requires a discount rate to be chosen to calculate the present values of cash inflows and then the payback is the number of years required to repay the initial investment. Yet payback can give misleading answers.
ProjectYear 0Year 1Year 2Year 3-4,0002,5005,500-4,0002,5001,800-4,0003,180The cost of capital is 10% per annumProject ANet cashDiscount factorPresentCumulativeat 10%valuespresent values-2,000-2,000-2,000-1,545-1,1305,0003,7502,620Project BNet cashDiscount factorPresentCumulativeat 10%valuespresent values-2,000-2,000-2,000-1,5451,8001,494Project CNet cashDiscount factorPresentCumulativeat 10%valuespresent values-2,000-2,000-2,0001,8001,638-362The payback rule does not take into consideration any cash inflow that occurs after the cut-off date. For example if the cut-off date is two years, project A although clearly the most profitable on the long term will be rejected. Thus if a firm uses the same cut-off regardless of project life then it will tend to accept many poor short lived projects and reject many good long lived ones.
Accounting rate of returnThe accounting rate of return (ARR) is a simple measure sometimes used in investment appraisal. It is a form of return on capital employed. ARR is calculated in the following way:
ARR= average accounting profit over the project x 100%Initial investmentWe here see that ARR is based on profits rather than cash flows and that it ignores the time value of money. It therefore just gives