NPV Better Investment Criteria Homework Help & Tutoring
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Criteria:
NPV as a better investment criteria
Although there are several investment appraisal techniques, NPV ranks as a better
investment criteria among the other appraisal techniques. This is because of the
disadvantages of other techniques which act as a strength for NPV method.
NPV method has the following advantages over pay-back period method:
NPV method has the following advantages over pay-back period method:
- It considers time value of money.
- It considers the cash flows over the entire economic life of the project.
- Considers the possibility of re-investment of the cash flows at a hurdle rate.
- Gives more weight to those money values which are nearer to the present period than those which are farther from it.
- Pay-back period bears a little relationship to whether the project will increase shareholder's wealth.
Advantages over Average or Accounting Rate of return method:
- NPV takes into account directly the amount of expenses and revenues over the project’s life. In case of average rate of return, the average profits are taken, which cannot be considered as an exact measure.
- Consideration of TVM.
- Consideration of realistic cash flows rather than accounting profit.
- ARR method also bears a little relationship to whether the project will increase shareholder’s wealth.
Advantages over IRR method:
- NPV method makes possible comparison of projects requiring different capital outlays, having different lives and different timings of cash flows, at a particular moment of time because of discounting of all cash flows. This becomes a difficult task with IRR method, though it is possible in IRR too.
- IRR calculation becomes difficult especially when there are unconventional cash flows and thus trial and error method has to be applied.
- In some cases of mutually exclusive projects, NPV and IRR would result in different results. NPV may say "yes" to a project where IRR says "no". In such situations, it is better to adopt the NPV method because according to NPV method, the project giving the highest NPV will be selected. Highest NPV is consistent with the goal of maximizing the shareholder's wealth. Naturally because higher the NPV, higher the project will generate profits, which would ultimately increase the share prices and stockholder's equity.
- NPV will give superior results when compared to IRR even in case of projects which conflict in rankings by both NPV and IRR methods.
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