Critical Analysis of NPV – FOR CAPITAL BUDGETING DECISIONS, BY JENNY CAMERON, BUSINESS ANALYST

A critical discussion on Net Present Value in finance

To make sound investment decisions we must assign a value to a stream of earnings in order to determine the present value (PV). Discounting is the method used to deal with this; the process is called discounted cash flow (DCF), and the amount of money left after discounting is known as the net present value (NPV). If the NPV is positive the project should be accepted because it signals the enhancement of shareholder’s wealth, and where there are two (or more) competing projects, the project with the highest NPV should be selected, as suggested by Atrill & McLaney (2021).

There are two types of investment appraisal methods, from the DCF method: the NPV and the Internal Rate of Return (IRR) methods are used, and for the Non-DCF method: the Accounting Rate of Return (ARR) and the Pay-back period (PP) are used.

Capital Asset Pricing Model (CAPM) used to weigh the potential returns of investments against its risks, a slightly more complicated approach to the cost of equity taking the systematic risk element into account. According to CAPM, an investor’s needed rate of return on a share consists of two components: a risk-free rate comparable to what can be obtained on a risk-free investment in short-term government securities, and an extra premium to offset the systematic risk associated with share purchases. This systematic risk for a company’s shares is measured by the size of its beta factor. A beta the size of 1.0 for a company means that its shares have the same systematic risk as the average for the whole market. If the beta is 1.4 then the systematic risk for the share is 40% higher than the market average, as demonstrated by Barrow (2011).

Atrill & McLaney (2021) argues that the NPV method considers all the costs and benefits of each investment opportunity, and logically accounts for the timing of such costs and benefits.

Time is an important factor, the same amount of collected in a year may have a different value than the amount paid out. An appraisal technique should distinguish the benefits arising within 12 months of the money invested, or the cost of financing the project over time, if not it could be a flawed appraisal approach. Therefore for an investment to be worthwhile, it must be greater than the opportunity cost of the money invested.

The NPV investment appraisal method is most commonly used and logically favoured, because all positive NPV enhance shareholders’ wealth, when comparing rival project investments of varying sizes, the discounting brings cashflows at different points in time to a common valuation basis (it’s Present Value), making direct comparisons possible. The ARR approach may cause issues as it doesn’t directly correspond to shareholders’ wealth, nor does it consider the timing of cashflows and all pertinent facts. Using the PP method is useful for projects that can recoup their cost quickly and amplifies liquidity, and since PP considers the timing of cashflows and employs cashflows instead of accounting flows, it is an improvement above using the ARR approach, however it is not a comprehensive solution in comparison to the NPV approach. Whereas the IRR method still takes account of the timing of cashflows, still gives signals as an NPV, and considers all pertinent information however, inferior to the NPV approach due to its detachment to the shareholders’ wealth into consideration, it can mislead when comparing against rival projects of different sizes, and present problems of multiple IRRs when there are unconventional cashflows.

Please refer to the appraisal methods calculation formulas.

Financial Technology – FINTECH: Practical component

Development of finance programme – NPV Calculator

Application of the Net Present Value – NPV Calculator used designed on Python by Jenny Cameron shown below to calculate the NPV concepts:

• Users such as investors may evaluate the expected investment returns momentarily to gauge levels of risk involved when committing a project, by first using the NPV calculator as the appraisal method.
• The calculator through its coded programming application then displays the results that provide users in making a better informed decision.
• Please refer to Figure 2. for the practical component of NPV Calculator.

Figure 2. The practical component of NPV Calculator by Jenny Cameron, executable by Python & GUI.

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