Why NPV Net Present Value is best method of Evaluating Projects

Why NPV Net Present Value is best method of Evaluating Projects

An investment project is attractive and should be pursued so long as the discounted net present value of cash inflows is greater than the discounted net present value of the  investment  requirement,  or  net  cash  outlay.    Because  the  attractiveness  of individual projects increases with the magnitude of this difference, high NPV projects are inherently more appealing and preferred to low NPV projects.   Any investment project that is incapable of generating sufficient cash inflows to cover necessary cash outlays, when both are expressed on a present value basis, should not be undertaken. In the case of a project with a NPV = 0, project acceptance would neither increase nor decrease the value of the firm.   Management would be indifferent to pursuing such  a  project.    NPV  analysis  represents  a  practical  application  of the  marginal concept, where the marginal revenues and marginal costs of investment projects are considered on a present value basis.  Use of the NPV technique in the evaluation of alternative investment projects allows managers to apply the principles of marginal analysis in a simple and clear manner.   The widespread practical use of the NPV technique  also  lends  support  to  the  view  of  value  maximization  as  the  prime objective pursued by managers in the capital budgeting process.

Just as acceptance of NPV > 0 projects will enhance the value of the firm, so too will acceptance of projects where the PI > 1, and the IRR > k.   Conversely, acceptance of projects where NPV < 0, PI < 1, or IRR < k would be unwise and reduce the value of the firm.   Because each of these project evaluation techniques share a common focus on the present value of net cash inflows and outflows, they display a high degree of consistency in terms of the project accept/reject decision.


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