Capital Budgeting Npv Essay

1806 Words Oct 1st, 2013 8 Pages
Capital Budgeting
Net Present Value
Theoretical Background
The capital budgeting decision is basically based on a cost-to-benefit analysis (Chatfield & Dalbor, 2005). The cost of the project is the net investment and the benefits of the project are the net cash flows. Comparison of these constituents ultimately leads to project acceptance or rejection.
As suggested by Bester (nd.), there are many advantages to using net present value as a capital budgeting evaluation technique. Some being as follows: * Incorporates the risk involved with a specific project. * Will depict the potential increase in firm value (i.e. the increase in shareholder wealth). * The time value of money is taken into account. * All expected
…show more content…
NPV is the difference between the sum of the present values of the future cash flows, and the present value of the cash outflows, i.e. the initial investment (Brealey et al, 2008).

Subsequently, the basic rule of thumb for the acceptance/rejection decision is as follows: * A positive cash flow (NPV > 0): the project should be accepted. * A negative cash flow (NPV < 0): the project should be rejected.
One of the biggest advantages of using NPV, as already mentioned, is that it takes into account the time value of money (this being an attribute of the other popular DCF method, IRR, too). NPV relies heavily on the discount rate when evaluating projects, which in turn relies on the appropriate risk measure for the specific project.
A longitudinal study in the United Kingdom by Pike (1996) examined the use of evaluation procedures and techniques used in capital budgeting over a 17 year period, from 1975 – 1992, and found that the NPV is a discounted cash flow method that was well established among the large firms, with 74% using this specific method. Additionally, the NPV was the method with the most growth over the review period. Specifically, 42% of the survey’s sample introduced the NPV method into their decision making (Pike, 1996). It is suggested that the reason for this may be due to more interest and understanding of the importance of the time value of money in capital budgeting techniques (Pike, 1996). There is a popular view

Related Documents