Definition: The Net Present Value or NPV is a discounting technique of capital budgeting wherein the profitability of investment is measured through the difference between the cash inflows generated out of the cash outflows or the investments made in the project.
The formula to calculate the Net Present value is:
Net present value = n∑t=1 Ct / (1+r)t – C0
Where, Ct = cash inflow at the end of year t
n= life of the project
r= discount rate or the cost of capital
Co= cash outflow
Accept – Reject Criteria: If the NPV is positive, the project is accepted.
Merits of Net Present Value
- It takes into consideration the Time Value of Money.
- It measures the profitability of the entire project by considering the profits throughout its life.
- It is easy to alter the discount rate, by just changing the value of the denominator.
- This method is particularly suitable for the mutually exclusive projects.
- It is consistent with the objective of maximizing the net wealth of the company.
Demerits of Net Present Value
- The forecasting of cash flows is difficult because of several uncertainties involved in the operations of the firm.
- It is difficult to compute the discount rate precisely. And this is one of the crucial factors in the computation of net present value as with the change in the discount factor the NPV results also changes.
- Another problem is that it is an absolute measure, it accepts or rejects the projects only on the basis of its higher value irrespective of the cost of initial outlay.
Thus, to compute the Net Present value, a firm should determine the cash inflows and the outflows along with the discount rate or a rate of return that firm desires during the lifetime of the project.