The Net Present Value method

1. Net sur retrovert Value ApproachThe Net Present Value method acting, which abides with the time assess of m wizardy principle, is a expectant pulmonary tuberculosis appraisal method, which seeks the total future bread currency inflow/outflow the project will append in todays terms. Indeed, the expected net cash inflow/outflow of every course is displaceed with a appeal of capital prize determined by the company. There is not standard cost of capital that cease be used, because it is different for every organization and project undertaken. The main components of discounting are the rising prices rate, the find-free component, general risk premium and property-specific risk premium. These stem from the cost derived from the finance medium selected, risk of the project failing to provide the anticipated cash inflows and the rate of kick the bucket attained from comparable capital projects. The factors mentioned above will differ between companies and projects, thus sub stantiating the point of no standard discount rate.Both the net return method and the other techniques described below hold the following assumptions Uncertainty does not exist. Random and unexpected fluctuations are therefore not considered in the capital expenditure appraisal method. A perfect capital market exists, which implies that unlimited funds can be obtained with the market rate of come to set.The higher the net present value attained, the much fiscally viable is the project at hand. With the excommunication of the time value of money concept, no other qualitative characteristics are considered by this method.1.1 Internal put of ReturnThis method also uses the time value of money concept. Under this technique, the discounted cash flow principle is utilise in a less practical way. The inborn rate of return is determined in this method normally by trial and error. This is the point at which the projects will break-even lede to a zero net present value. A capital pro ject is financially viable if the congenital rate of return is greater than the discount factor applied for the project. In fact, the higher the internal rate of return the greater the financial feasibility of the project at hand, because the higher is the margin of safety of the project not incurring a loss.1.2 Modified Internal Rate of ReturnAs its name implies this is a modified capital expenditure appraisal technique of the method described in the previous section. The modification mainly stems from compounding all positive cash flows forward to end of the capital project duration. The figure attained by the modified internal rate of return method is the one that portrays the present value of all cash outflows together with the future value of all cash inflows.The internal rate of return weakness that is mitigated by this method, which is also defined in the next section, is the multiple root problem that is encountered when discounting cash outflows to the present date.1.3 Adv antages and Limitations of Capital Project evaluation MethodsThe adoption of discounting, which adheres with the time value of money principle, which takes into account important personal line of credit and economic factors such(prenominal) as the inflation rate, the risk-free component, general risk premium and property-specific risk premium is considered both by the internal rate of return, modified internal rate of return technique and net present value method. even off though they are more complex in nature and require more technical calculations, these deuce-ace methods provide valuable financial entropy of a much better quality due to such feature.When the capital projects evaluated are not mutually exclusive and can be considered independently during the valuation, the net present value method and the internal rate of return approach will provide identical results, leading to the same decision. However, the scale of the project is properly considered by the former capita l expenditure appraisal model, because it is an direct measure of the projects financial return. On the contrary, the internal rate of return system adopts a relative measure to the projects size and cash flow timing in congress to initial capital expenditure. Therefore when projects are mutually exclusive and ranking is necessary in the business valuation, these two methods may provide dissimilar results. The net present value method provides financial information of greater quality in such instances because it directs towards the capital project that holds the highest increase in financial wealth for the organization. In addition, the ranking exercise is much easier to apply when the net present value method is adoptive for mutually exclusive projects.The internal rate of return model can also provide take information when cash flows are non-conventional in the capital project examined. In such cases, a nada or a vast number of internal rates of return may be derived, which wo uld render the application of such method useless. This problem does not apply to the net present value method.Even thought, the internal rate of return method had been improved by the adoption of the modified internal rate of return technique the net present value method is still the best method that an organization can adopt in order to value its capital projects. We ought to keep in mind that only one limitation is removed with the application of the modified internal rate of return method. In this section more were noted, that may provide inaccurate financial information leading to wrong decisions.ReferencesBrockington B. R. (1993). Financial Management. Sixth Edition. capital of the United Kingdom DP Publications.Drury C. (1996). Management and Cost Accounting. Fourth Edition. New York International Thomson Business Press.Lucey T. (2003). Management Accounting. Fifth Edition. bulky Britain Biddles Limited.Randall H. (1999). A Level Accounting. Third Edition. Great Britain Ashf ord Colour Press Ltd.