What Is the Connection Between NPV and Capital Budgeting?

The net present value method is to convert the net cash flow of the project over its entire life cycle into the sum of its present values based on a predetermined target rate of return. The sum of the net present value is also equal to the algebraic sum of the present value of all cash inflows and the present value of all cash outflows. ^[1]

Net present value method

Net present value method: a method of evaluating investment options. The method is to use

Net present value = Total present value of future returns-Total construction investment NPV =

Where: NPV-net present value; NFC (t) represents cash in year t

1. Use cash flow. Companies can directly use the cash flow from the project. In contrast, profits include many human factors. Profit is not equal to cash in capital budget.

2. The net present value includes the entire cash flow of the project. Other capital budgeting methods often ignore the cash flow after a certain period. Such as the payback method.

3. The net present value discounts the cash flow reasonably. Some methods often ignore the time value of money when dealing with cash flow. Such as payback period method, accounting rate of return method.

(1) The determination of the cost rate of funds is difficult, especially in the case of economic instability, and the interest rate of the capital market often changes, which makes it more difficult to determine.

(2) The net present value method describes the total profit and loss of the investment project, but fails to account for the unit's investment effectiveness, that is, the actual return on investment of the investment project itself. This will cause the investment plan to focus on selecting projects with large investments and high returns, and neglecting better investment solutions with small investments, small returns, and high return on investment.

Considering the risk based on the net present value method, two kinds of uncertainty are obtained

Time value of capital: one dollar today> one dollar tomorrow

The net present value method is based on the principle that it is assumed that the estimated cash inflows can be realized at the end of the year, and the original investment is treated as scheduled

1. Determination of discount rate. The net present value method takes into account

Net Present Value = Total Present Value of Future Returns-Investment Present Value

(1) No advance working capital and no net residual value

The NPV indicator is an indicator that reflects the profitability of a project's investment.

NPV decision criteria

The scheme of net present value 0 is feasible;

Schemes with a net present value <0 are not feasible; schemes with a net present value> 0 are both the best.

Advantages of the net present value method

1. The net present value discounted the cash flow reasonably, taking into account the time value of funds, and enhancing the evaluation of investment economics

(Some methods often ignore the time value of money when processing cash flows. For example, payback period method, accounting rate of return method.)

2. Considering the entire cash flow during the calculation period of the project, it reflects the unity of liquidity and profitability.

3. Considering the investment risk, a high discount rate is adopted for large risks, and a low discount rate is adopted for small risks.

4. The net present value can clearly reflect the amount of value added (or depreciated) to the enterprise by engaging in an investment. A positive net present value represents the added value of the enterprise value.

Disadvantages of the NPV method

1. The calculation of NPV is cumbersome and difficult to master

2. Measurement of net cash flow and discount rate and discount rate are difficult to determine

3. It cannot directly reflect the actual income level of the investment project from a dynamic perspective, nor can it reflect the return rate of the program itself.

4. When the amount of project investment varies, it is impossible to accurately judge the pros and cons of the plan, and it cannot be used for comparison between independent plans.