NPV Theory

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NPV Theory

NPV Benefits

  1. it considers the time value of money (that is in the discount rate used)

  2. it gives an absolute figure not a percentage

  3. it considers the whole life of the project

  4. is based on real cashflows .

  5. It maximises the wealth of shareholders as this increases through receiving dividends and rising share prices.

  6. Positive NPV investments should increase the market value of the company by the amount of the NPV.

A company with a market value of $10 million investing in a project with an NPV of $1 million will have a market value of $11 million once the investment is made.

Shareholder wealth is therefore increased

NPV method also contributes towards the objective of maximising the wealth of shareholders by using the cost of capital of a company as a discount rate when calculating the present values of future cash flows.

A positive NPV represents an investment return that is greater than that required by a company’s providers of finance, offering the possibility of increased dividends being paid to shareholders from future cash flows (see later)

NPV drawbacks

  1. The reliance placed on the cost of capital - this can be tricky to calculate (as we shall see later)

  2. Inflation rates are assumed to be constant in future periods. In reality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables

  3. it is heavily dependent on the production and sales volumes forecasts

  4. It does not adjust the cash flows in future years for their lack of predictability compared to earlier years

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