This week we focus on understanding the power new present value methodology in e

Question

This week we focus on understanding the power new present value methodology in evaluating various alternatives and in deciding on the best alternative. There are several questions that can bring up in this discussion.
1. Why is the tool so powerful? 2. What are it’s shortcomings? 3. What are other alternatives methodology presented in the chapter and how does NPV stack up against them? 4. Have you used this methodology in your work or even in your personal decisions when selecting amongst alternatives. 5. Provide some examples from work or from current news or the business case that you are working on to highlightsthe use of this methodology This week we focus on understanding the power new present value methodology in evaluating various alternatives and in deciding on the best alternative. There are several questions that can bring up in this discussion.
1. Why is the tool so powerful? 2. What are it’s shortcomings? 3. What are other alternatives methodology presented in the chapter and how does NPV stack up against them? 4. Have you used this methodology in your work or even in your personal decisions when selecting amongst alternatives. 5. Provide some examples from work or from current news or the business case that you are working on to highlightsthe use of this methodology
1. Why is the tool so powerful? 2. What are it’s shortcomings? 3. What are other alternatives methodology presented in the chapter and how does NPV stack up against them? 4. Have you used this methodology in your work or even in your personal decisions when selecting amongst alternatives. 5. Provide some examples from work or from current news or the business case that you are working on to highlightsthe use of this methodology

Explanation / Answer

1. NPV or Net present value methodology in evaluating investment decision is very powerful and widely used. NPV is very widely used as the method ranks the alternatives and provides which is the top choice. It considers time value of money and thus decision will consider inflation, cost of capital etc. It captures all financial benefits of the future and thus financial decision leveraging NPV is widely used.

2. NPV captures only financial results of the future and calcualtes the today's value for the same. Any non financial benefit like reputation, good will, social benefits are not captures through this model. Also, if the project is of short duration (< 1year or so), NPV will not be of significant use.

3. Other alternatives to NPV are Internal rate of return, payback period.

Payback period considers the future cashflows, but doesnt consider time value, thus short term projects will be biased in this method. NPV is more accurate.

IRR mentions selecting a project if its returns are higher than the cost of capital. NPV states that a project providing positive NPV will add value to firm. Thus IRR and NPV will similarly provide same accept/reject regarding a project.

4 & 5. Yes, NPV is used in my personal decision for evaluating a business opportunity. Basis workings considering the future cashflows (profits post all expenses), cost of capital calculated basis rate of return on alternative investments, and current investment required. Using the calculations, the opportunity turned out be NPV -ve, and thus helped in making a decision of not going ahead with it.

The same can be used to decide between different investment options - Fixed income options vs other savings options, Business opportunity A vs Business opportunity B, Buying real estate vs Fixed income options etc.

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