The main purpose of investment is to maximize shareholders’ wealth by improving the value of the firm. Firms invest to replace existing equipment, for expansion, and for compliance with government regulations. There are three categories of investment decisions: acceptance or rejection, ranking of projects, and choosing between projects. To assess whether it is viable to invest or not the NPV technique can be used to compare the present value of returns and costs. If the NPV is negative it implies that costs exceed returns and hence it would not be advisable to invest in such projects. There are also other investment appraisal techniques that are employed apart from the NPV; these are the pay back method, accounting rate of return and internal rate of return method.
Net present value (NPV) is generally considered as the most correct method for investment appraisal because it focuses on cash and takes into account the time value of money and riskiness of the investment project. The method is hence consistent with the objective of shareholder wealth maximization (Shapiro, 2005). The net present value of an investment project is the present value of the net cash inflows less the project’s initial investment outlay. If the resulting NPV is positive, the company should accept the investment project; if it’s negative, the project should be rejected. In mutually exclusive projects, the investment with higher net present value should be accepted (Drury, 2004).
The use of NPV technique, which is the most appropriate to evaluate investment projects, require the identification of a discount rate that is to be used in the calculations. The discount rate should represent the opportunity cost of capital to the firm taking the investment decision.
The key strength of the method is that it evaluates investments in the same way as shareholders do and thus maximizes shareholder value. The NPV criterion also obeys the value...