Answer

The theoretical rationale for the Net Present Value (NPV)

            Net present value (NPV) is a capital budgeting technique that is used by organizations and individuals to make investment decisions. Organizations are usually faced with the challenge of choosing the best projects to invest scarce resources in to maximize returns and gain competitive advantage.  In the case of mutually exclusive projects, where the choice of one project means foregoing investment in another project, net present value technique is used to decide which project to invest in.  Other capital budgeting techniques that are used by organizations to make capital budgeting techniques include internal rate of return (IRR), payback period method and profitability index method. With the exception of payback period method, the other investment evaluation techniques use discounting techniques to determine the future returns of a project. Projected future cash flows from a project are discounted using a discounting rate to get the present value of the cash inflows and outflows to determine the returns from the project (Pressacco, Magni & Stucchi, 2012).  The present value of cash inflows or cash benefits from a project are deducted from the present value of cash outflows or costs to determine the net present value of a project. The formula for determining Net Present Value (NPV) is shown below.

 NPV= C_n / (1+k)ⁿ-C_o

Whereby;

C_n   =>  cash inflows at time period “n” in years

K => the required rate of return or discounting rate

n => the time period in years

C_o represents the initial amount of money that is invested in a project to generate future benefits which usually future cash inflows from a project. 

Net present value calculates the actual value of a firm in monetary terms by conceptualizing the value as present value of cash inflows less the present value of the cash out flows.  The basic concept of net present value is the understanding that money at hand is better than money to be received sometime in future which in other words is the concept of time value of money.  Net present value concept encourages businesses to collect their debts early while taking as long as possible to pay their creditors.  The rationale for this is that money loses value due to adverse effects of such factors as inflation, bankruptcy or unexpected future events. A debtor can also run into difficulties and fail to pay money when it is due such as after being declared bankrupt.  Future cash inflows are uncertain because they are not guaranteed as a creditor can encounter a myriad of challenges that would make him unable to meet his financial obligations.  Time value of money is the rationales behind net present value concept.  The concept basically implies that money at hand is worth more than money to be received sometimes in future. Money at hand can be invested to increase its value while inflation would reduce the amount of goods that the same amount of money could buy in future (Rich & Rose, 2014). Net present value demands that businesses must observe proper procedures when undertaking long term capital investments. They should ensure the resource allocation to undertake a project is much less than the projected benefits from the project implemented to maximize shareholder wealth.  Employing appropriate capital budgeting techniques before making a decision to invest in a project is critical because capital investments are very costly and cash inflows from such a project are spread over a long time.  Net present value is one of the most commonly used capital budgeting techniques that is used to determine the viability of a project before an investment decision is made on it(Weber,  2013).

            The rationale of net present value method is that it seeks to maximize shareholder wealth by comparing a project’ costs and it benefits. The method recommends that the project with the highest net present value as the most viable investment to maximize shareholder wealth.   Making investment decisions is rather straight forward when using net present value method.  Net present value method recommends that management selects projects with a positive NPV as the costs incurred to implement them will be lower than potential benefits or target rates of return from the project.  Net present value method enables a company to avoid investing in projects whose net present value is negative or zero. Companies should avoid projects with a negative net present value. If a company invests in such a project the costs of implementing the project will be more than the benefits and hence the company will lose money.  A company may however implement in a project with a negative net present value if the project is a social project which has other valuable intangible benefits (Weber,  2013).  For example when a government builds a bridge or a school, it may not be able to determine the net present value of such a project but the social benefits are usually very high. Another example, is when the government invests in a school, the future cash inflows may not be easily determinable but the school has immense social benefits.  Organizations should also avoid investing in projects that have a zero net present value because such a decision has high opportunity costs(Weber,  2013). The decision to invest in any given project is the alternative investment opportunities that the money could have been used to implement. 

Other methods of making capital budgeting techniques

            Other capital budgeting techniques includes internal rate of return, profitability index and payback period. Internal Rate of Return (IRR) is the rate of return that ensures that the Net Present Values of all cash flows from a project are equated to Zero. This implies that it is the rate of return that ensures that the present value of cash inflows from a project and the present value of cash out flows from the same project are equal (Osborne, 2010). Internal Rate of Return is a rate that is normally derived through a trial and error method or by plotting the figures in Ms. Excel and using an excel formula to arrive at the rate (Osborne, 2010). The Internal Rate of Return stipulates that the project with the highest IRR should be accepted.  The IRR must also be higher than the required rate of return (Osborne, 2010).  Payback period method determines the duration that a project takes to payback the initial investment. A project with a shorter desirable payback period is chosen over projects with a long payback period. Usually management sets a desired payback period and its projects that meet that payback period that pass the cutoff point.  For those projects that have met the cutoff point, organizations prefer projects with the least payback period. This method does not take into account time value of money and ignores cash flows after the payback period in its analysis (DUDLEY JR.,  1972).

Investors use the ratio of payoff to investment of a proposed project to determine the profitability index of a project. Profitability index determines the relationship between project benefits and costs incurred to implement the project. Profitability index allows investors to quantify the amount of investment benefits per one unit of investable capital.  The formula for calculating profitability index is a shown below.

Profitability index = Present value of future cash inflows divided by initial investment. A profitability of 1 indicates that a project has met its breakeven point.  A profitability index of less than 1 implies that the present value of cash inflows from a project are less than the initial investment and hence such a project should be rejected. A project with a profitability index of more than 1 should be accepted as it means the present value of cash inflows from a project are more than the initial investment into the project (Singh,  Jain & Yadav, 2012). 

Companies use more than one method to make investment decisions rather than relying on just one method because of various reasons. One of the reasons is that by using several methods companies want to confirm whether each method arrives at the same conclusion or whether the same investment decision runs through all the investment techniques (Osborne, 2010). The other reason is that all methods have certain shortcomings and by using many methods a company tends to neutralize the limitations of each other method. The next reason why companies use several methods is because of the consequences of making a wrong investment decision (Osborne, 2010).  Wrong investment decisions and especially those that involve large sums of money can easily lead to bankruptcy if the projects fail. Companies need to be sure that the project they are implementing is the correct one and the numbers look impressive.  In many cases, companies borrow money from financial institutions to undertake expansion projects. If they invest wrongly they will still have to repay the loan plus interest which puts pressure on the cash flows (Yashin, Koshelev & Makarov, 2011). To enhance the chances of success, companies use several investment methods. Companies also use several investment methods to ensure that the projects they undertake have a very high probability of success. If a project fails then a signal is send to the market about the quality of management, it has reputation risk consequences and stock price might fall especially if it is a public company (Yashin, Koshelev & Makarov, 2011).

            A project’s IRR measures profitability of an investment’s capital that has not been recouped by an investor and still remains in a project. Project analysts come to the same conclusions whether they use IRR or NPV (Yashin, Koshelev & Makarov, 2011).   An IRR is used to rank projects as the higher a project’s IRR is, the more desirable it is to investors.  Investors have pointed out that NPV is unable to calculate benefits versus costs in many projects and should be augmented by IRR (Yashin, Koshelev & Makarov, 2011).  However IRR is not suitable for long term projects whose discount rates keep on changing as it is useful in comparing similar projects with similar risk profiles, predictable cash flows, short life spans and same discount rates. In instances where the cash flows from a project move from positive cash flows to negative cash flows then to positive cash flows for maybe two years then negative cash flows again for a while(Yashin,  Koshelev & Makarov, 2011).

            A project can have more than one IRR as market conditions change which makes it difficult to make an investment decision.  Net Present value criteria can handle projects using many discount rates as each cash flow is discounted separately(Yashin,  Koshelev & Makarov, 2011).  In some cases it may not be practical to use a project’s IRR and more so in instances when the cost of capital is not known.  To make a wise investment decision to invest or not, IRR must be compared to a discount rate (Yashin, Koshelev & Makarov, 2011). When the discount rate is not known, the most ideal method to use in investment appraisal is NPV. In the case of NPV, when the discount rate is zero (0%), Net Present Values is simply total cash flows less total cash outflows. The highest NPV occurs when the discount rate is zero. For discount rates higher than IRR the NPV of the project is negative (Yashin, Koshelev & Makarov, 2011).

            One of the other possible methods that could be used for investment appraisal is payback period. Payback period is the exact amount required for the firm to recover its initial investment in a project as calculated from cash inflows. In the case of a mixed stream of cash inflows the yearly cash inflows are accumulated until the initial investment is recovered (Velez-Pareja, 2013).  The investment decision criteria is that if the payback period is less than the maximum acceptable payback period set by management then the project should be accepted but if the payback period is greater than the acceptable payback period then the project should be rejected. One of the drawbacks of this method is that the benchmark payback period is simply a subjective number set by management and the method does not take into account the time factor in the value of money.  This investment technique is not as useful as NPV as it ignores the effects of time in the value of money(Liesen, Figge & Hahn, 2013).  Cash inflows from projects with a long investment horizon may post a good payback period while according to NPV technique it records a negative NPV.  This is because NPV method takes into account the impact of inflation on the value of money to be received in future. The other capital investment method is by using the profitability index. The profitability index or benefit-cost ratio of a project is the ratio of the present value of future net cash flows to the initial cash outlay. The investment decision criteria is that if the profitability index is 1 or greater than 1 the project should be accepted but if it is less than 1  then the project should be rejected. The main drawback of this method is that when funds are being rationed it will not yield positive figures. When ranking different proposals with different investment scales this method may not yield useful findings (Kierulff, 2012).

            In investment projects investors consider  other non monetary costs and benefits  which are not captured by NPV, IRR, and payback period and profitability index.       Non-monetary aspects are important because of a number of reasons. Non-monetary aspects present project benefits that cannot be quantified. Such benefits might include the strategic benefits of the project to the national economy in solving a national problem, the number of jobs created to assist in reducing unemployment numbers, etc. Other non-monetary aspects of a project appraisal include demand and supply forecasts, risk assessment, quality of management etc as all these will determine whether the monetary costs and benefits will be realized.  It is crucial for an investor to appraise the business environment as it influences the outcomes of the company.   Numerical analysis is also a very important aspect of investment appraisal. Numerical analysis provides a basis for measuring actual performance versus projected performance. Numerical analysis assists in demonstrating how an investment will grow a company’s net worth and enhance its market value.ash flows (Johnstone, 2008)

Disadvantages and advantages of NPV

            Net present value method is not without its share of disadvantages. One of the most notable is that NPV is based on future cash flows. It is generally accepted that it is difficult to estimate with precision future cash flows.  Most investors rely on questionable sources to project future cash inflows from a project. The net present value method ignores opportunity cost to making investments. The method does not recognize that any investment decision has opportunity costs and the method does not have it built in to the calculation of net present value of a project.  Discerning investors use internal rate of return to determine the gain or loss in a project in addition to using NPV method (Liesen, Figge & Hahn, 2013).  The main advantage of this method of capital budgeting is that it is easy to use and to understand and that it recognizes the effects of inflation on money. The formula helps investors to allocate scarce resources wisely and optimally to maximize shareholder wealth. Net present value also helps investors to know that future money is less valuable as it can buy less good that if it was at hand currently.  Net present value is a useful tool in evaluating companies for mergers and acquisitions.  Net present value technique is also advantageous because it give a solid number to work with. However, the technique does not take into account the size of an organization (DUDLEY JR., 1972). It can therefore make an organization make an investment that does not maximize returns.  While IRR can give conflicting answers e.g. a project having Two IRR’s, net present value technique only gives one answer(Altshuler & Magni, 2012).  Net present value actually measures the amount of value that will effectively be added into a project after it’s completed.  The major disadvantage of the techniques of NPV, payback period, profitability index and internal rate of return is that they rely on a lot of assumptions which makes it impossible to get a definitely correct answer. All methods involve projecting future cash inflows in term of amounts and when exactly they will be received which is not practical. Determining the correct discounting rate is also a problem. Lastly, these techniques ignore non monetary benefits from a project which might outweigh the initial investment by far (Altshuler & Magni, 2012).

Conclusion

Net present value is one of the most commonly used capital budgeting techniques all over the world. The method is used to determine the net present value of mutually exclusive projects.   To determine the net present value of a project analysts discount future cash inflows to their present value using a discount rate determine in advance. In most cases, the discounting rate used is the weighted average cost of capital of a company.  The total present value of cash inflows is subtracted from the initial investment to arrive at the net present value of the investment. If a project records a negative net present value the recommended investment decision is to reject the project. If however a project has a positive net present value the recommended investment decision is to invest in the project. However, in such a case if the number of mutually exclusive projects with a positive NPV is high the recommended investment decision is to select projects with the highest NPV.  There are other capita budgeting techniques that investors use to make decisions on the best projects to invest in. Other capital budgeting techniques that are used include internal rate of return (IRR), the profitability index and the payback period.  Each of these capital budgeting techniques has advantages and disadvantages. It is therefore recommended that investors use more than one capital budgeting techniques in making capital investment decisions