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Explain the theoretic rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
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Explain the theoretic rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. Present value (PV) is the current value of future cash flows discounted at the appropriate discount rate. Therefore the present value of £400,000 one year from now must be less than £400,000 today. After all, a pound today is worth more than a pound tomorrow, because the pound today can be invested to start earning immediately. Thus, the present value of a delayed payoff may be found by multiplying the payoff by a discount factor which is less than one. If C1 denotes the expected payoff at time period 1 (1 year hence), then Present Value (PV) = discount factor * C1 This discount factor is expressed as a reciprocal of 1 plus a rate of return: Discount factor = 1 1+r The rate of return (r) is...
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