• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

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.

Extracts from this document...

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.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our University Degree Political & International Economics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related University Degree Political & International Economics essays

  1. Advantages and disadvantages of Comesa.

    In terms of African trade, there has been little structural transformation, with trade being dominated by exports of primary commodities. In 1993, 86 per cent of Africa's foreign exchange earnings were derived from primary commodities, including crude petroleum, whereas 73 per cent of the total value of imports was accounted for by manufactured goods.

  2. Discuss the differences, advantages and disadvantages between payback, IRR, ARR, and NPV.

    compare future cash flows with the initial investment after they have been discounted to their present values. Payback, as mentioned earlier only offers an estimate as to what cash flows will be in later years, and in some cases this may cause problems as cash flow after the payback period has finished can take a sudden decline.

  1. This paper gives an overview of an investment advice that involves analyzing the basic ...

    The effects of time are not too difficult to work out; however, corrections of risk are much more important determinants of many securities' values.1 The prices of many assets are not easily observed such as potential public or private investment projects, new financial securities, buyout prospects and complex derivatives.

  2. Implications for the macro-economy of the central bank adopting an interest rate rule. ...

    Pre Fed appears to move policy generally in the same direction as Modern Fed, but employs smaller interest rate changes.20 For example, Pre Fed's interest rates fall to near-zero in the mid 1930s and rise to a maximum of 10 percent in the mid-1940s compared with a rate about double that for Modern Fed.

  1. EXCHANGE RATE IN BANGLADESH

    Taka convertible for current account transactions, and since then on, a managed but flexible exchange rate policy has been followed. Currently, the Taka is pegged to a currency basket of its 15 main trading partners, in the weighted form, still with the UD $ as the intervention currency.

  2. Political Implication of Globalization.

    At the cultural level, globalization threatens the final extinction of local cultures. But in the financial realm, the aura of doom that seems to hang over globalization's irreversibility confronts us with our own inability to imagine any alternative. One further dimension of economic globalization, is that of the so-called 'culture of consumption'.

  1. AT Kearney management consulting report for Acer.

    1 Demand Conditions The demand conditions of Taiwan are the weakest link of the diamond. Domestic demand only plays a small role of Taiwan's total production. Their labour costs are relatively high compared to neighbouring nations and local consumers feel they receive unfair treatment.

  2. &amp;quot;The Relationship between The Nominal Interest Rate On Bonds and Desired Investment Expenditure Appears ...

    are high interest rates then people are more likely to save money, and will therefore demand less, and visa versa. In a financial market the supply of money must equal the demand for it if there is to be equilibrium.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work