Question 4.RQ.1: Why is the net present value method of investment appraisal ...
Why is the net present value method of investment appraisal considered to be theoretically superior to other methods that are found in practice?
NPV is usually considered the best method of assessing investment opportunities because it takes account of:
■ The timing of the cash flows. Cash flows associated with each project are discounted according to when they are expected to arise. By discounting, using the opportunity cost of capital, the time value of money is recognised.
■ The whole of the relevant cash flows. NPV includes all of the relevant cash flows irrespective of when they are expected to occur. This means that they are all taken into account when making the investment decision.
■ The objectives of the business. NPV is the only method of appraisal where the output of the analysis has a direct bearing on shareholder wealth. (Positive NPVs enhance wealth; negative ones reduce it.) Since most private-sector businesses aim to maximise shareholder wealth, NPV is the best approach to use.
NPV provides clear decision rules concerning acceptance/rejection of projects and the ranking of projects. It is fairly simple to use, particularly with the availability of modern computer software, which takes away the need for manual calculations.