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# Explain the theoretical 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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Introduction

Financial Decision Making Essay Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. Introduction Net Present Value (NPV) is defined as the different between an investment's market value and its cost. NPV rules states that we will accept the project if it creates a positive NPV, and will reject the project if the NPV < 0. In other words, NPV is a measure of how much value being created today by undertaking investment. Managers need to make investment decisions and calculating NPV can help them to see the likelihood of investment being profitable. There are a variety of ways to estimate net present value, such as the discounted cash flow approach and the discounted payback method etc. However, there is risk, because there is no guarantee that the estimations will turn out to be correct. The other two commonly used approaches are Internal rate of return (IRR) ...read more.

Middle

More over, it is easier to use for problems where choices involving ranking or choosing between several projects. For example, we have 3 projects each generates different NPV values, �10m from the first one, �4m from the second one and -�1m from the last one. So it is clear to see the first project with the �10m NPV is the most profitable project to invest. On the other hand, the disadvantage of NPV is that there is no indication of interest rate sensitivity. This involves in calculating the expected NPV of a project. For example, the value of a particular variable we will take, if the NPV expected from the project is to be reduced to zero may be ascertain and the difference in value expressed as a percentage of its most likely value. This provides indications of the sensitivity of the project expected NPV to changes in the value of individual variables, and points to this estimates where a small deviations will be critical for this assess of failure of the product. ...read more.

Conclusion

It is the present value of an investment's future cash flows divided by its initial cost. The rule of IP is to take the project if index exceeds 1. It measures the present value of an investment per dollar invested. It is closely related to NPV but similar to IRR it cannot be used to rank mutually exclusive projects. But, sometimes it is used to rank if the firm has more than one positive NPV investments it can take at present. Conclusion The NPV approaches which link directly to the measurement of present value which helps to managing finance decisions in maximising firms' net cash inflows. If a firm makes wrong decisions on NPV analysis, so the firm will make losses. The advantages of NPV are it gives immediate cash values of the project. It is easy to make decisions involve ranking between several projects. However, there are no implications for interest rate sensitivity. The IRR approach which give the implication of interest rate uncertainty, but this is more complicated to use between projects. The IP cannot be used to rank mutually exclusive project like IRR, but it can be used to rank projects if there are more positive NPV investments. ...read more.

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