Question

Explain investment decision through Net Present Value (NPV) method.

Answer 1

The Net Present Value (NPV) method is a widely used and reliable technique for making investment decisions. It evaluates the profitability of an investment project by comparing the present value of expected future cash inflows with the initial investment cost.

Net Present Value (NPV) is the difference between the present value (PV) of cash inflows and the present value of cash outflows (initial cost) over a period of time:

NPV = `sum(R_t/(1+r)^t)-C`

Where:

• R_t​ = Net cash inflow during the period t
• r = Discount rate (cost of capital)
• t = Time period (years)
• C = Initial investment

Example:

A company considers investing ₹ 100,000 in a project that is expected to generate ₹ 40,000 per year for 3 years. The required rate of return is 10%.

Step 1: Calculate PV of inflows

NPV = `(40,000)/(1+0.10)^1+(40,000)/(1+0.10)^2+(40,000)/(1+0.10)^3-100,000`

= 36364 + 33058 + 30053 - 100000

= ₹ -525

Since NPV is negative, the project should be rejected.

Advantages of NPV Method:

• Considers time value of money
• Accounts for all cash flows throughout the project’s life
• Based on profitability, not accounting figures

Limitations:

• Requires accurate forecasting of cash flows
• Depends on the correct choice of discount rate
• Not as intuitive as some other methods (e.g., Payback Period)