comparison of investment rules
The comparison of NPV & Other investment rules
Comparison of NPV & Other Investment Rules
Capital budgeting is important for a company to make decisions on investments and financing issues. However, there are various methods can be used for corporate financing, among which Net Present Value (NPV) is the best rule which can always lead to the correct choices. Except NPV, the company can also use payback period, discounted payback period method, the internal rate of return (IRR) and the profitability index (PI). The following is the analysis and comparison of NPV and these alternatives.
NPV is the profit a company can obtain from its project and the increase in the value of the shareholders. It considers all estimated cash flows in a project’s life and discounts them to the present value by discount rate to make them comparable. After summing all the present value generated in every period, the company can get the NPV which is the value additivity. This important value additivity can only be directly generated and seen thought NPV rule, while other alternatives cannot provide such information. The company should accept the project only if the NPV is larger than zero and reject it when the NPV is below zero. The discount rate used in calculation should be estimated regarding to the risk level or the expected return of the project, however, it need to be adjusted based on the differences from market risk. NPV rule is suitable for all situations because time value of money and risk of cash flow are both taken into account. Nevertheless, managers still need to be aware of the accuracy of the estimations of cash flow and expected return.
Payback period method is to compare the length of the time required for recovering the initial cost of an investment. This method only considers the cash flows generated during the payback period and ignores the cash flow after that. Besides, it also ignores the time value of money while in NPV calculation future cash flows
Comparison of NPV & Other Investment Rules
Capital budgeting is important for a company to make decisions on investments and financing issues. However, there are various methods can be used for corporate financing, among which Net Present Value (NPV) is the best rule which can always lead to the correct choices. Except NPV, the company can also use payback period, discounted payback period method, the internal rate of return (IRR) and the profitability index (PI). The following is the analysis and comparison of NPV and these alternatives.
NPV is the profit a company can obtain from its project and the increase in the value of the shareholders. It considers all estimated cash flows in a project’s life and discounts them to the present value by discount rate to make them comparable. After summing all the present value generated in every period, the company can get the NPV which is the value additivity. This important value additivity can only be directly generated and seen thought NPV rule, while other alternatives cannot provide such information. The company should accept the project only if the NPV is larger than zero and reject it when the NPV is below zero. The discount rate used in calculation should be estimated regarding to the risk level or the expected return of the project, however, it need to be adjusted based on the differences from market risk. NPV rule is suitable for all situations because time value of money and risk of cash flow are both taken into account. Nevertheless, managers still need to be aware of the accuracy of the estimations of cash flow and expected return.
Payback period method is to compare the length of the time required for recovering the initial cost of an investment. This method only considers the cash flows generated during the payback period and ignores the cash flow after that. Besides, it also ignores the time value of money while in NPV calculation future cash flows