Financial Advantages And Disadvantages Of The NPV Model

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Before agreeing to any project, that has medium or long term effects on the company, a financial analysis has to be done. It is necessary to find out the financial effects before spending any money on it.

Investment appraisal techniques

Every model has advantages and disadvantages, so it is advisable to use more than one for any given project.

Net Present Value (NPV)

The NPV model is the most common method analysing investment decisions. It measures capital growth, which is the fundamental goal of financial management. NPV is an absolute measure of a project’s profitability. NPV includes all expected future cash flows, the time value of money, and the risk of the future cash flows.
An NPV greater than zero means that the investment
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Takes into account both the timing and the magnitude of cash flows.

Disadvantages of NPV: It is uneasy to estimate the discount rate for a long-term period. NPV cannot handle a negative amount in the cash flow other than the initial
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Considers both the magnitude and the timing of cash flows If the IRR is high enough, estimation of the required return might not be necessary.

Disadvantages of IRR: IRR is not good for comparing two mutually exclusive investments. In case of change in sign (+,-) of cash flows result in as many IRR’s as the number of changes are in the cash flow directions of the investment. Consequently, unconventional cash-flow values result in multiple IRR values.

Profitability Index (PI)

The profitability index is the ratio of the present value of future expected cash flows subsequent to initial investment divided by the amount of the initial investment. This measure shows the relative profitability of any investment by showing the ratio of the benefit from an investment to the cost. In other words, the index represents the value for each invested dollar. The profitability index considers all cash flows, the timing of cash flows, and the riskiness of cash flows – the same way as NPV does. PI is a ratio and relative amount, whereas NPV is a difference and as an absolute amount. Using PI and NPV, in mutually exclusive projects, may result in dissimilar

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