15.8 Discounted cash flow methods: net present value

Question 1

What is “net present value” (NPV)?

Answer 1

The net value of a capital investment/project obtained by discounting all cash outflows and inflows to their present values by using a discounted rate of return.

Question 2

How is NPV calculated for a project appraisal?

Answer 2

NPV = present value of cash flows - present value of cash outflows

Question 3

What is the decision rule for NPV project analysis?

Answer 3

The project should be undertaken is NPV is positive.

Question 4

What are the advantages of the NPV method of project appraisal?

Answer 4

• theoretically superior to all others
• considers time value of money through the discount rate
• is an absolute measure of return
• accounts for all cash flows throughout the life of the project
• maximises shareholder wealth by undertaking projects that will have surplus profits.

Question 5

What are the disadvantages of the NPV method of project appraisal?

Answer 5

• can be difficult to explain to managers (as it uses cash flow not profit)
• discount rate calculation can be challenging
• quite complex compared to other methods