Making Capital Investment Decisions

Question: Examine and discuss the characteristics of NPV and the role that this method plays in capital investment decision making. Discuss the advantages of using this method instead of the other evaluation methods? Answer: Net Present Value is considered as the present value in context to future cash outflows and inflows. It is used usually in capital budgeting in order to study the profitability or success of any investment or project. Therefore, it largely used by the organizations to make budgeting decisions so that they can gain profit in future. Moreover, the NPV helps the organizations in predicting the future losses or profit from any particular project or investment (Baldwin and Clark, 1991). On the other hand, it is explained as the variation between present value of cash outflow and cash inflows. Moreover, the discounted cash flow method is used for the valuation of net present value so that cash flow value of project can be known (Bierman and Bierman, 1988). Apart from that, if Net Present Value is positive then it shows a positive sign for the company and adds value to them and if the NPV is negative then the industry should not make decision to make an investment in that particular project (Burger and Hawkesworth, 2013). Therefore, if the NPV is higher than the investor can plan to make investment. If It means Then NPV greater than zero The investment will add value to the industry The project can be accepted NPV less than zero The investment will decrease the value of the industry The project can be eliminated or rejected NPV equal to zero The investment will neither generate income nor loss The investor can make decision relying on strategic positioning or on the basis of other factors. The NPV can be better understood from an example, Year Cash Inflow Discount Factor (10%) Present Value of Cash Flow 1 3400 .909 3090.6 2 4000 .826 3304 3 6000 .751 4506 4 2100 .683 1434 Total 12335 Initial Investment 8000 Net Present Value 4335 Therefore, it can be understood that project can be accepted as it shows positive value above the initial investment value. The Net Present Value is effective as it helps in making comparisons of multiple numbers of potential investments. Therefore, the investor can take decision whether to make investment or not (Clark, Hindelang and Pritchard, 1979). Moreover, time value of money is accounted by net present value. Further, the future revenue can be converted by NPV to current dollars which assist the company to quantify the value of the project (Montier, 2010). Apart from that, Net Present value has advantage over other investment appraisal techniques such as payback period and accounting rate of return. These techniques do not consider the discount future cash flows but it is taken in account under NPV. On the other hand, if a certain investment has non-normal cash flows then NPV is a better option than IRR (Pratt and Grabowski, 2010). The non-normal cash flow arises when there is huge cash outflow at the end of any investment. Therefore, IRR cannot be applied. Moreover, in case of evaluation of mutually exclusive projects then Net Present Value is viable option than IRR method (Sinclair, 2010). On the other side, NPV provides more realistic reinvestment rate predictions than other appraisal techniques. Moreover, the NPV provides best indicator regarding shareholder wealth and profitability and provide best decision basis (Clark, Hindelang and Pritchard, 1979). References Baldwin, C. and Clark, K. (1991). Capabilities and capital investment. [Boston]: Division of Research, Harvard Business School. Bierman, H. and Bierman, H. (1988). Implementing capital budgeting techniques. Cambridge, Mass.: Ballinger Pub. Co. Burger, P. and Hawkesworth, I. (2013). Capital budgeting and procurement practices. OECD Journal on Budgeting, 13(1), pp.57-104. Clark, J., Hindelang, T. and Pritchard, R. (1979). Capital budgeting. Englewood Cliffs, N.J.: Prentice-Hall. Montier, J. (2010). Value Investing. Hoboken: John Wiley Sons. Pratt, S. and Grabowski, R. (2010). Cost of capital. Hoboken, N.J.: Wiley. Sinclair, D. (2010). Capital budgeting decisions using the discounted cash flow method. Can J Anesth/J Can Anesth, 57(7), pp.704-705.