NPV Method

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This is generally considered to be the best method for evaluating the capital investment proposals. In case of this method cash inflows and cash outflows associated with each project are first worked out. The present values of these cash inflows and outflows are then calculated at the rate of return acceptable to the management. This rate of return is considered as the cut-off rate and is generally determined on the basis of cost of capital suitably adjusted to allow for the risk element involved in the project. Cash outflows represent the investment and commitments of cash in the project at various points of time. The working capital is taken as a cash outflow in the year the project starts commercial production. profit after tax but before depreciation represents cash inflow. The Net present value (NPV) is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

 

The equation for calculation NPV is case of conventional cash flows can be put as follows:

 

R1                   R2                   R3                   Rn

NPV =            —— +             ——- +            ——– +           ———

(1 + k)             (1 + k)2           (1 + k)3           (1 + k)n

 

Incase of non-convential cash inflow (i.e. where there are a series of cash inflows as well cash outflows ) the equation for calculating NPV is as follows:

 

 

R1                   R2                   R3                   Rn

NPV =            —— +             ——- +            ——– +           ———

(1 + k)             (1 + k)2           (1 + k)3           (1 + k)n

 

 

11                    12                    13                    1n

10        —— +             ——- +            ——– +           ———

(1 + k)             (1 + k)2           (1 + k)3           (1 + k)n

 

Where NPV = Net present value, R = Cash Inflows at different time periods, K Cost of Capital or Cut-off Rate, 1 = Cash outflows at different time periods.

 

Accept or reject criterion. The net present value can be used as an accept or reject’ criterion. In cash the NPV is positive (i.e., present value of the cash inflows is more than present value of cash outflows) the project should be accepted.

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