The Theoretical Rationale For The NPV Approach To Investment Appraisal Essay

The Theoretical Rationale For The NPV Approach To Investment Appraisal Essay

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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.

One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.

The main stages in the capital budgeting cycle can be summarised as follows:
• Forecasting investment needs.
• Identifying project(s) to meet needs.
• Appraising the alternatives.
• Selecting the best alternatives.
• Making the expenditure.
• Monitoring project(s).

One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional methods and discounted cash flow techniques.

The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique that relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment, where opportunity cost is the "calculation of what is sacrificed or foregone as a result of a particular decision".
If you receive cash you are likely to save it and put it in the bank. Thus, what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.

In o...


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...he initial costs by the cash flow per year provides the cash-flow payback. It is the length of time required to recover the project's initial capital charges and expenses. The larger the cash-flow payback (i.e., the longer the payback period), the riskier the project. However, the cash-flow payback method neither accounts for the time value of money nor does it credit the income following payoff of the initial costs. In other words, it provides no information about the return rate for the investment made during the project.

No one of the above financial measures is adequate for project prioritisation. Most firms use two or more of these financial measures to prioritise projects. Since economic evaluations are done using spreadsheets, there is no reason not to calculate all these financial measures, and then use the appropriate ones during project prioritisation.

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