Question

Net Present Value (NPV) analysis of a project reveals + $3 600 based on a discount rate of 12%. What does this tell us about the financial viability of the project? What does it not tell us? Why is the NPV method considered to be theoretically superior to other methods such payback or ARR?

Answer 1

Net present value (NPV) refers to difference between present value of cash Inflow and present value of cash outflow. If NPV is positive than it indicates that the project is profitable and if it is negative than the project is not viable financially. Here, NPV is +$3600 at 12% discount rate. This means that the project is financially viable.

What does it above information do not tell us ?

1) As the discount rate is constant at 12%, NPV does not reflect the the changing risk factor that the project may face at different time period.

2) NPV fails to reflect the overall gain or loss in executing the project in percentage terms. We have to calculate IRR to know the percentage gain over the cost of project.

Why is the NPV method considered to be theoretically superior?

Payback method means time taken by a project to recover its cost. It measures time not the financial viability in money terms. Low payback period makes the project more attractive. While the work of payback method stops as soon as the project breaks even. It ignores any benefit after the payback. NPV on the other hand takes into account profitability of the project in money terms. It uses time value of money to measure risk factor in the project which payback method completely Ignores.

Average rate of return (ARR) means difference between aggregate cash flows during the project lifetime and the Initial investment divided by the initial investment. It ignores time value of money i.e, the risk factor that ensues the project.

That is why NPV method is considered superior to both Payback and ARR, theoretically.