Critically evaluate the use of NPV approach in proposed inve

Critically evaluate the use of NPV approach in proposed investments?

Solution

Answer: NPV is the difference between PV of cash inflows minus PV of cash outflows.

NPV discounts the future cash flows of a project by using a determined discount rate (often the WACC). It is able to determine the increase in wealth (today) that would result from undertaking a project. It enables management to compare projects of different types and to make correct capital budgeting decisions.

Should projects be independent, all projects with positive NPV should be accepted. If projects are mutually exclusive, the project with the higher (positive) NPV should be accepted. A project with a negative NPV is not a good investment, as it would decrease the value of the company and therefore also the wealth of the shareholders. NPV is the preferred approach in principle, if not always in practice