Net Present Value (NPR) (HL IB Business Management)

• The Net Present Value (NPV) takes into account the effects of interest rates and time
  
• It recognises
  • The fact that that money received in the future is often worth less than money received today (inflation)
  • The opportunity cost of not having the money available for other uses
     
• To calculate the Net Present Value of an investment, the value of all future net cash flows in today’s terms need to be calculated first and then discounted using a table
  

• The cost of the initial investment is deducted from the total of the discounted net cash flows
  • If future net cash flows minus the initial investment are positive, then the investment is likely to be worthwhile
  • If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile
    
    
• Discounted cash flows are calculated using discount tables, which allow future cash flows to be expressed in today’s terms
   

Table: Discount factors at Different Rates of Interest

 
Advantages and Disadvantages of the Net Present Value Method

• Each techniques relies upon forecasted future cash flows which may lack accuracy
  • Managers may lack experience or may be biased towards a particular investment
  • Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited
     
• Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons
  • Unexpected increases in costs
  • The arrival of new competitors
  • Changes in consumer tastes
  • Uncertainties arising as a result of economic growth or recession
    
    
• Non-financial factors are ignored
  • Business finances and availability of external finance to fund the investment
  • Overall corporate objectives 
  • Potential for positive public relations or meeting social responsibilities