The net present value method is understood to be the best available method for evaluating capital investment proposals. Under this method, the cash outflows and inflows associated with each project are ascertained first. Cash inflows are worked out by adding depreciation to profit after tax arising to each project. Since the cash outflows and inflows arise at different points in time and cannot be compared, so both are reduced to the present values at the rate of return acceptable to the management. The rate of return is either cost of capital of the firm or the opportunity cost of capital to be invested in the project. The assumption under this method remains that cash inflows are reinvested at the same discount rate.
Advantages of the NPV Method:
(i) Income over the entire life of the project is considered.
(ii) The method takes into account the time value of money.
(iii) The method provides clear acceptance so interpretation is easy.
(iv) When projects involve a different amount of investment, the method may not provide satisfactory answers.
(v) This method considers the firm objective of wealth maximization concept for the shareholders.
Disadvantages of the NPV Method:
(i) As compared with the first two methods, the present value approach is certainly more difficult to understand and apply. It requires special skills for calculation.
(ii) An additional difficulty in this approach is encountered when projects with unequal lives are to be evaluated.
(iii) It is difficult to determine the firm cost of capital or appropriate rate of discount.
Suitability of NPV Method:
Net present value is the most suitable method in those circumstances where the availability of resources is not a constraint. The management authority can accept all those projects having Net Present Value either Zero or positive. This method shall maximize shareholder’s wealth and market value of share which is the sole aim of any business enterprise.
The Modified Net Present Value Method:
One of the limitations of the NPV method is that the reinvestment rate in the case of NPV is the Cost of Capital (k). However, in the case of MNPV, different reinvestment rates for the cash inflows over the life of the project may be used. Under this modified approach, the terminal value of the cash inflows is calculated using such expected reinvestment rate (s). Thereafter, MNPV is determined with the present value of such terminal value of the cash inflows and the present value of the cash outflows using the cost of capital (k) as the discounting factor.