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Basic Financial Management
Notes Net Present Value Method (NPV)
The net present value method is one of the discounted cash flow methods. It is also known as
discounted benefit cost ratio method. NPV can be defined as preset value of benefits minus preset
value of costs. It is the process of calculating present values of cash inflows using cost of capital
as an appropriate rate of discount and subtract present value of cash outflows from the present
value of cash infl ows and find the net present value, which may be positive or negative. Positive
net present value occurs when the present value of cash inflow is higher than the present value
of cash outflows and vice versa.
Formula
NPV = PV of Cash inflow – Pv of cash fl ow
Notes Steps involved in computation of NPV
1. Forecasting of cash inflows of the investment project based on realistic assumptions.
2. Computation of cost of capital, which is used as discounting factor for conversion of
future cash inflows into present values.
3. Calculation of cash flows using cost of capital as discounting rate/factor.
4. Finding out NPV by subtracting present value of cash outflows from present value of
cash infl ows.
Accept-Reject Rule
Acceptance or reject rule of the project is decided based on the NPV.
Accept: NPV> Zero
Reject: NPV< Zero
Consider: NPV= Zero
Advantages of NPV Method
The Merits of NPV are
1. It takes into account the time value of money.
2. It uses all cash inflows occurring over the entire life period of the project including scrap
value of the old project.
3. It is particularly useful for the selection of mutually exclusive projects.
4. It takes into consideration the changing discount rate.
5. It is consistent with the objective of maximization of shareholders’ wealth.
Limitations of NPV Method:
NPV is the most acceptable method in comparison with traditional methods. Nevertheless, it has
certain Limitations also.
1. It is difficult to understand when compared with PBP and ARR.
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