Net Present Value ( Npv )

1530 WordsMar 11, 20167 Pages
Net present value (NPV) is a discounted cash flow technique used to determine the overall value of a project or a succession of cash flows (Blocher et al, 2008). See Appendix 1 for a simplified calculation. Belli (2001) argues that NPV is more suitably applied to mutually exclusive projects; these types of projects are those that if accepted, prevent other contending projects to be approved (Mowen et al, 2009). NPV is understood to be an absolute measure, therefore when selecting between mutually exclusive projects, the project with the highest NPV tends to be the most desirable (Damodaran, 2010). NPV is a popular appraisal technique, largely owing to its ability to consider the concept of time value for money. This alone provides a more…show more content…
However, if the projects are mutually exclusive IRR is argued to be problematic and not the most effective technique. Ranking projects according to desirability can be flawed due to the inferred reinvestment rate assumption of IRR and/or due to projects being of varying size and duration (Fisher, 1930). One of the most cited problems with IRR appears to be the fact that a cash flow stream can have no internal rate of return or numerous, inconsistent internal rates (White et al, 1998). This particular drawback is epitomised in Lorie and Savage 's (1955) oil-well problem. They found that investing in advanced oil pump equipment to extract large quantities of oil at a faster pace could cause negative incremental cash flows. Moreover, it increased the total recovery and shifted some of the oil that had been recovered to date, to earlier periods; this caused the cash flow pattern to fluctuate between negative and positive. These problems caused them to state that, "the rate-of-return criterion for judging the acceptability of investment proposals is ambiguous or anomalous (Lorie and Savage, 1955, p228). Payback period is defined as "the expected number of years required to recover the original investment" (Brigham & Ehrhardt, 2005, p347). The payback period is calculated by cumulatively adding the net cash flows of a project. Projects with a shorter payback period are generally considered the most desirable
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