Net Present Value And Other Investment Criteria

1552 words - 7 pages

The purpose of this paper is to explain the importance of net present value along with other investment criteria used in determining the value of business decisions regarding today’s investments for future returns. The paper will define what is meant by net present value and show how managers can use it as an analysis tool to decide if an investment is worth the calculated risk. Also, there will be three methods discussed that managers can use to propose the best financial projects to invest in to increase revenue for its owners. The methods discussed will include: the net present rule, the payback rule, and the internal rate of return. With each method there will be an explanation of their ...view middle of the document...

There are advantages to each of these methods, but managers should be respectful of the disadvantages associated with these calculation tools as well.
The challenges for all managers is deciding what types of investments should be made, the length of time allotted for a particular investment, and the method at which to finance both long term and short term activities (Ross, Westerfield, & Jordan, 2011). The first approach is the net present value method. In this method managers need to understand the meaning of cash assets in terms of net present value in order to make the best lucrative decisions possible. The net present value is the worth of future cash flows respective to the value of today’s cash assets to be invested. This method considers the value of today’s cash assets regarding the amount of time and the expected rate of return or interest rate from the initial investment for it to be considered as worthwhile investment. The desired return of investment for the manager is determined by “the nature of the business enterprise and its relative profitability, the purpose of the capital investment, the cost of securing funds for the investment, and the minimum desired rate of return (Net Present Value Method, 2011).” Simply put, if the initial investment brings in more cash flow than what it costs, without negatively affecting any other corporate decision, then it is a good financial decision. A manager always wants the net present value of an investment to be positive to keep increasing company value. If a proposed investment with a selected rate of return is going to have a negative net present value then the decision is not in the best interests of the company and should be rejected.
Net Present Value (NPV) = investment market value – its costs
There are some advantages in the net present value analysis method. One advantage for the manager using this method according to Kirk Thomason is its calculation based on “dollar for dollar (2014).” This calculation takes the future cash flow values and presents them in today’s dollar values giving a clearer picture when evaluating the best project for future growth. Another advantage in NPV method is the consideration in the company’s costs in acquiring funds for investing in future growth. They can also factor in projected inflation costs and opportunity costs over a given period of time (Daniel, 2011). These costs are added into the calculation which is a useful benefit when comparing projects using debt versus company equity (Thomason, 2014). A manager must contemplate the disadvantages associated in NPV as well. For one, the amount of information needed to make the right analysis can be troublesome when looking at various propositions. Thomason states one option may give a boost in revenue, whereas another option helps to reduce costs (2014). Another disadvantage may be the manager realizes that another calculation method may be better suited.
Another approach to be used is the...

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