Answers:
The Net Present Value (NPV) method
is the classic economic method of evaluating the investment proposals. It is a
DCF technique that explicitly recognizes the time value of money. It correctly
postulates that cash flows arising at different time periods differ in value
and are comparable only when their equivalents—present values—are found out.
The following steps are involved in the calculation of NPV:
- Cash
flows of the investment project should be forecasted based on realistic
assumptions.
- Appropriate
discount rate should be identified to discount the forecasted cash flows.
The appropriate discount rate is the project’s opportunity cost of
capital, which is equal to the required rate of return expected by
investors on investments of equivalent risk.
- Present
value of cash flows should be calculated using the opportunity cost of
capital as the discount rate.
- Net
present value should be found out by subtracting present value of cash
outflows from present value of cash inflows. The project should be accepted
if NPV is positive (i.e., NPV > 0).
Acceptance
Rule
- Accept
if NPV > 0 (i.e., NPV is positive)
- Reject
if NPV < 0 (i.e., NPV is negative)
- Project
may be accepted if NPV = 0
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