Net Present Value

1.NPV should be universally used to value projects

2.Compare and contrast the investment appraisal rules and explain how the NPV criterion can be used to address the problems of “capital widening”and “capital deepening”

3.The only appropriate decision making rule for investment decisions is the NPV

Investment decision rules are usually referred to as capital budgeting techniques.The best technique will posses the following essential property:It will maximize shareholders’wealth.This essential property can be broken down into separation criteria:

All cash flow should be considered

The cash flow should be discounted at the opportunity cost of funds

The technique should select from a set of mutually exclusive projects the one that maximizes shareholders’wealth.

Managers should be able to consider one project independently from all others(known as the value-additivity principle)There are four widely used capital budgeting techniques:1.the payback method 2.the accounting rate of return 3.the net present value 4.the internal rate of return

1.The payback method

The payback method for a project is simply the number of years it takes to recover the initial cash outlay on a project.The difficulty of this method is that it does not consider all cash flows and it fails to discount them.Failure to consider all cash flow results in ignoring the large negative cash flows that may occur.So this method should be rejected because it violates (at least)two of the four properties that are desirable in capital budgeting techniques.

2.The accounting rate of return:

ARR is the average after-tax profit divided by the initial cash outlay.It is very similar to the return on assets(ROA)or the return on investment(ROI)

ARR=average after-tax profit/initial outlay

they suffer from the same deficiencies.The problem with the ARR is that it uses accounting profits instead of cash flows and it does not consider the time value of money.

Net present value

The NPV...