Explain the theoretic rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.

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Explain the theoretic rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.

Present value (PV) is the current value of future cash flows discounted at the appropriate discount rate.  Therefore the present value of £400,000 one year from now must be less than £400,000 today.  After all, a pound today is worth more than a pound tomorrow, because the pound today can be invested to start earning immediately.  Thus, the present value of a delayed payoff may be found by multiplying the payoff by a discount factor which is less than one.  If C1 denotes the expected payoff at time period 1 (1 year hence), then

Present Value (PV) = discount factor * C1

This discount factor is expressed as a reciprocal of 1 plus a rate of return:

Discount factor = 1

                              1+r

The rate of return (r) is the reward that investors demand for accepting delayed payments.  To calculate present value, future payoffs are discounted by the rates of return offered on alternative investments.  This is called the discount rate or opportunity cost because it is the return forgone by investing in the project rather than in securities.  Take for example the opportunity cost is 7%.  Present value can be obtained by dividing the cash flow (for example £400,000) by 1.07.

PV = discount factor * C1 = 1 * C1 = 400,000 = £373,832

                                   1+r              1.07

Therefore you would have to invest £373,832 in order to receive £400,000 at the end of the year.  Net present value (NPV) follows on from finding the present value as I will now explain.

An investment is worth undertaking if it creates value for its owners.  In the most general sense value is created by identifying an investment worth more in the market place than it costs to acquire.  The difference between an investment’s market value and its cost is called the net present value of the investment, which is abbreviated NPV.  In other words, net present value is a measure of how much value is created or added today by undertaking an investment.  In general an investment should be accepted if the net present value is positive and likewise rejected if it is negative.  Say for example you bought a building that is now worth £373,832, this does not however mean that you are £373,832 better off.  Say you committed £350,000, and therefore your net present value is £23,832.  Net present value (NPV) is found by subtracting the required investment:

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NPV = PV - required investment = 373,832 – 350,000= £23,832

In other words, the building is worth more than it costs- it makes a net contribution to value.  The formula for calculating NPV can be written as:

NPV = Co + C1

                     1+r

However, it is important to remember that Co, the cash flow at time period 0 (that is, today) will usually be a negative number.  In other words, Co is an investment and therefore a cash outflow.  In the example above, Co ...

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