Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV is used to evaluate an investment assessment and give company management a plain way to tell if the investment will add value to the company.
Advantages of Net Present Value (NPV)
- NPV gives important to the time value of money.
- In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered.
- Profitability and risk of the projects are given high priority.
- NPV helps in maximizing the firm’s value.
The NPV method produces a dollar amount that indicates how much value the project will create for the company.
The obvious advantage of the net present value method is that it takes into account the basic idea that a future dollar is worth less than a dollar today.
Disadvantages of Net Present Value (NPV):
- NPV is difficult to use.
- NPV cannot give an accurate decision if the amounts of investment of mutually exclusive projects are not equal.
- It is difficult to calculate the appropriate discount rate.
- NPV may not give the correct decision when the projects are of unequal life.
The NPV method is not applicable when comparing projects that have differing investment amounts.
The biggest disadvantage to the net present value method is that it requires some guesswork about the firm’s cost of capital.