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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AF 1522 Financial Decision Making

Library No: 0253027

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) and profitability index (PI).  

Main

        An investment is worth undertaking if it creates value for its owners.  Under certain situations, using the net present value rule maximises share price and maximises shareholders’ wealth.  For example, a housing company is considering a proposal to build new block of flat.  Required initial investment is £10m. Payoffs are cash flows of £2m in year 1, and £5m each for the next 2 years.

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Investors require a 10% return on this type of project.  Should we accept this project?  One way to calculate the NPV for this project is the Discounted cash flow.  Discounted cash flow (DCF) is the process of valuing an investment by discounting in future cash flow.  The way to work this out is to find the present value of the future cash flows at the return investors require and subtract the initial outlay.  

NPV = -10 +   2     +    5     +   5       = £ 2.224m

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