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5.3.4 Net Present Value
Net present is one of the techniques whereby the discounting of cash flows is done which serves as a good measure of profitability. NPV is the sum of all incremental cash flows if a project is undertaken. The discount rate used is the firms cost of capital adjusted for risk of the project. For a normal project where there is initial cash outflow and then it's followed by a series of after tax cash inflows. The NPV in such case will be present value of the expected cash inflows minus the initial cost of the project. This can be represented in formula as:
K is the required rate of return or the cost of capital adjusted for the risk of the project that the firm has undertaken.
A project having Positive NPV will increase shareholders value and will be profitable, while projects with negative NPV won't be profitable and will decrease shareholders value. So these projects should be rejected.
Calculate the NPV of each of the following project and comment which one should be accepted, given that cost of capital is 10%:
Year Project A Project B Project C
0 -3000 -3000 -3000
1500 300 1000
1200 900 1000
900 1200 1000
4 300 1800 1000
The NPV of all the projects are positive, so we can accept any of these projects, but had the projects been mutually exclusive then we should have chosen Project A because of highest NPV.
Also, if we look carefully the cash flows from the project are almost the same just that in Project A large inflows occur at the beginning of the project while in Project B it occurs at the end. Therefore project A has highest NPV, since more weight is given to cash flows which occur at the start of the project. The more lately a cash flow occurs; accordingly a less weight is assigned to it. As we can clearly see that Project B has the lowest NPV because of low cash flows in the beginning of the project and Project C has NPV in between of Project A and Project B.
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