Net present value method is one of the modern methods for evaluating the project proposals. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
It evaluates the viability of an investment option by using the concept of time value of money ..Money in the present is worth more than the same amount of money in the future. This is due to inflation and the earnings that can be made from alternative investments during that period. This concept is predominantly used in the areas of Capital budgeting and project financing, to name a few.
CALCULATION OF NPV
The NPV of an investment is calculated by adding the PVs ( present values ) of all of the cash inflows and outflows.
Formula for NPV
NPV = ((Cash Flows )/( 1+r )^t
Cash flows= Cash flows in the time period
r = Discount rate
t = time period
If NPV is positive , it shows that cash inflows from the project are greater than the cash outflows (costs ) of the project ,thus indicating that the project is profitable and must be selected by the investor .
On the contrary, a negative NPV indicates that the cash outflows are greater than the cash inflows from the project . Hence, it is not feasible to select the project. When the NPV is 0 , there is no gain or loss .
ADVANTAGES OF NPV METHOD
- This method is very easy to use and comparable .
- NPV can be easily customized which helps in reflecting the financial concerns and demands of the firm accurately .
DISADVANTAGES OF NPV METHOD
- It is very difficult to determine exact discount rate, the size of each cash flow, and when each cash flow will occur which is required for NPV .
- NPV fails to provide a complete picture of the exact gains and loss that may incur from a project as depicted by internal rate of return .
In simple words, NPV is the today’s worth of money which is anticipated to be earned in a particular future period, The higher the NPV the greater are the chances of the project being taken up for execution, in plain sense. Though there are a lot other indicators to be taken care of, NPV is one of the basic financial indicator to measure the feasibility of a project.