Explain the Theoretical Rationale for the Npv Approach to Investment Appraisal
Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
Forecasting investment needs.
Identifying project(s) to meet needs.
Appraising the alternatives.
Selecting the best alternatives.
Making the expenditure.
Monitoring project(s).
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional methods and discounted cash flow techniques.
The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique that relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment, where opportunity cost is the "calculation of what is sacrificed or foregone as a result of a particular decision".
If you receive cash you are likely to save it and put it in the bank. Thus, what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.
In other words, it is likely that the business will have borrowed the capital to invest in the project. So, what it foregoes by having to wait for the revenues (from the investment) is the interest paid on the borrowed capital.
Thus, NPV is
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
Forecasting investment needs.
Identifying project(s) to meet needs.
Appraising the alternatives.
Selecting the best alternatives.
Making the expenditure.
Monitoring project(s).
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional methods and discounted cash flow techniques.
The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique that relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment, where opportunity cost is the "calculation of what is sacrificed or foregone as a result of a particular decision".
If you receive cash you are likely to save it and put it in the bank. Thus, what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.
In other words, it is likely that the business will have borrowed the capital to invest in the project. So, what it foregoes by having to wait for the revenues (from the investment) is the interest paid on the borrowed capital.
Thus, NPV is