Net present value is an analysis method that discounts future dollars back to today's current value. The formula involves several pieces of information that allow a business to make informed decisions when reviewing several different projects. A few distinct advantages and disadvantages exist when a company decides to use net present value as its project selection tool.
Net present value is an analysis method that discounts future dollars back to today’s current value. The formula involves several pieces of information that allow a business to make informed decisions when reviewing several different projects. A few distinct advantages and disadvantages exist when a company decides to use net present value as its project selection tool.
The biggest advantage to net present value is its dollar-to-dollar analysis. A dollar today is not worth the same amount as a dollar tomorrow. When taking this concept several years into the future, it is easy to see why net present value has an advantage for project selection. Discounting the future cash flows for each project under review allows a company to compare the costs spent today to the potential dollars the project will bring in, in current dollar value.
Cost of Capital Comparison
Most companies use external funds when starting large projects. The cost of capital represents the interest a company pays on borrowed funds. Net present value includes a company’s cost of capital into the review stage. Companies can also use different cost of capital figures for different projects. For example, creating different mixes of debt and equity funds with slightly different cost of capital figures increases the net present value advantages.
Lack of Information
Net present value calculations require copious amounts of information when reviewing multiple projects. The inability to gather all necessary information or accurate information can weaken this analysis tool. Additionally, multiple project options with different information may be difficult to analyze. For example, one option may increase sales while another deceases costs. Comparing the information from these two options may result in different answers based on the gathered information.
Inappropriate Analysis Tool
Project analysis may require a different tool so a company can make an informed decision. Other analysis tools include payback period or internal rate of return. These tools may provide a better result than net present value. It is up to the company’s management team to decide which tool provides the best option for selecting an option from multiple projects. A financial analyst or other employee can often provide insight into the best tool to use.
- "Analysis for Financial Management"; Robert C. Higgins; 2010