Net Present Value (NPV, advantages and disadvantages)

The formula for calculating NPV can be written as:

NPV = (3.10)[16]

The C0 is a negative number. In other words, C0 is an investment and therefore a cash outflow. Most important point that NPV depends on forecasted cash flows. The simplest concept of cash flow is the difference between money received and money paid out. Sometime managers get mixed cash flow with accounting profit. Accountants try to show profit as it is earned rather then when the company and the customer get around to paying their bills, they sort cash outflows into tow categories: current expenses and capital expenses. They deduct current expenses when calculating profit but do not deduct capital expenses. Instead they depreciate capital expenses over a number of years and deduct the annual depreciation charge from profits. As a result, profits include some cash flow and exclude others, and they are reduced by depreciation charges, which are not cash flows at all. It is impossible to find cash flow by routine manipulations of accounting data. The cash flow always estimates on an after-tax basis. When manager make forecast of cash flow hi should make sure that cash flows are recorded only when they occur and not when work is undertaken or a liability is incurred.

When manager is deciding which cash flows should included in the value of project. Project value is estimated and depends on all the additional cash flows. The cash flows should be estimate on an incremental basis. Do not get confuse average with incremental payoffs.

It is very important to include all incidental effects on the value of project. These incidental effects can extend into the far future.

Manager should not forget about working capital requirements. Most projects entail an additional investment in working capital. This investment should recognize as cash flow forecasts. When the project comes to an end manager has possibility to recover some of the investment.

The cost of a resource may be relevant to the invest decision even when no cash flow changes. That is why manager should include opportunity cost in the value of project. Sometimes opportunity cost may be very difficult to estimate; however, where the resource can be freely traded, its opportunity cost equal to the market price.

The sunk costs are past and irreversible outflows. Because sunk costs are bygones, they cannot be affected by the decision to accept or reject the project, and they should be ignored.

When the accountant assigns overhead costs to the firm’s projects, a charge for overhead is made. The principal of incremental cash flows says that in investment appraisal manager should include only extra expenses that would result from the project. A project may generate extra overhead or it may not. Manager should be cautious about assuming that the accountant’s allocation of overheads represents the true extra expenses that would be incurred.