19-05-2012, 02:16 PM
Capital Budgeting
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NET PRESENT VALUE (NPV) METHOD
The NPV is the first and the foremost of the discounted cash flow techniques. NPV is used simply to weigh the elements of trade-off between investment outlays and the future benefits in equivalent terms, and to determine whether the net balance of the present values is favorable or not. The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with a proposal. In other words, the NPV of any proposal, that involves cash inflows and outflow over a period of time, is equal to the net present value of all the cash flows. Thus, the NPV is the sum of the discounted values of the cash flows of a proposal. In case, the cash outflows i.e. the investment in the proposal occur only in the beginning at time 0, then NPV may be defined as the sum, of the present values of cash inflows less the initial investment.
A rate of discount must be specified and applied to both inflows and outflows in order to find out their present values. When the present values of all inflows and. outflows are added, the resultant figure is denoted as net present value. The figure can be positive or negative, depending on whether there is a net inflow or outflow from the project. A word should be said about the rate of discount. From an economic point of view, this rate of discount should be the rate of return, the investor normally enjoys from investments of similar nature and risk. In effect, it is opportunity rate of return. In case of a firm, the choice of a discount rate is complicated by the variety of investments available and by the type of financing provided by both the shareholders and the debt investors. The rate so employed is the overall cost of capital, which takes into account shareholders expectations, business risk and the leverage.
The Critical Evaluation:
The capital budgeting decision is perhaps the most important and crucial decision of a finance manager because the capital budgeting is the main lever to increase or rather maximise the wealth of the shareholders. The central goal of the capital budgeting is to find out the proposal whose inflows have greater values than the outflows. The NPV as a technique of evaluation of capital budgeting proposals helps a finance manger in achieving this objective. If the firm invests its funds in those proposals whose NPV is either 0 or negative, then the proposal is not going to contribute anything to the wealth of the shareholders. Rather, it may even decrease the wealth. In as much as, the present value depends on both timing and the date of discount, a positive NPV indicates that over its economic life, the cash floes generated by the investment will recover the original outlay, earn the desired return, and in addition provide a cushion of excess value. Conversely, a negative NPV indicates that the project is not achieving the date of return and will this cause a loss. Obviously, the rate of return, the timing of the cash flows and the relative magnitude of cash flows will al effect the NPV.
The merits of the NPV technique can be enumerated as follows.
1. It recognizes the time value of money. It helps evaluation of proposals involving cash flows over a period of several years. The cash flows occurring at different point of time are not directly comparable, but they can be made comparable by the application of the discounting procedure.
2. The NPV technique considers the entire cash flow stream and all the cash inflows and outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the NPV.
3. The NPV technique is based on the cash flows rather than the accounting profit and thus helps in analysing the effect of the proposal on the wealth of the shareholders in a better way.
4. The discount rate, k, applied for discounting the future cash flows is in fact, the minimum required rate of return, which incorporates both the pure return as well as the premium required to set off the risk.
5. The NPV technique represents the net contribution of a proposal towards the wealth of the firm and is therefore, in full conformity with the objective of maximization of the wealth of the shareholders. The NPV concept has a built in earnings requirements in addition to the recovery of the investment. Thus, the cushion implicit in the positive NPV is truly an economic gain that goes beyond satisfying the required rate of return.
The above merits of the NPV technique make it a popular technique of evaluation of capital Budgeting proposals. The NPV technique appears to correctly reflect the trade-off of equivalent cash outlays and inflows, while allowing for both the recovery of the initial investment (principal) and the earnings at a pre-stipulated rate. The best use of NPV is as a screening device that indicates whether the minimum rate of return can be met by the proposal or not. When the NPV is positive, there is a potential for returns in excess of the minimum required return; when the NPV is negative, the minimum return and the capital recovery both cannot be achieved. When the-NPV is close to or approximately zero, the minimum required return is just met. The very fact that this technique is capable of evaluating the proposals that are profit seeking and involve cash flows over a period of several years makes it a preferred technique of evaluation of capital budgeting proposals. But this does not mean that it is free from shortcomings.