NPV stands for Net Present Value and it means actually a difference b/w the at hand value of cash inflow and the at hand of cash out flows. NPV is basically used for planning for future growth which will help to analyze the profitability of an anticipated investment or profitability of future project.
There are two types of NPV:
Positive NPV and that indicates the expected income
earned by plan or investment (in present) exceeds the anticipated costs. Usually, investment with a positive NPV will be a cost-effective one and with a negative NPV will result in a net loss. The basic concept of Net Present Value that decision for investment should be made with positive NPV values.
“NET PRESENT VALUE – NPV”
Formative the value of a plan is difficult because there are different ways to evaluate the value of future cash flows. Because of the time value of money (TVM), money in the present is worth more than the same amount in the future. The discount rate aspect of the NPV formula is a way to explanation for this. Organizations have different ways for identifying the discount rate; most common methods for shaping the discount rate include using the expected rate of return.
Drawback and alternative
One of the most common issue is measuring an investment’s profitability with NPV is that NPV relies a lot upon many assumptions and estimates, so there can be considerable room for error. Anticipated factors include investment costs, discount rate and expected returns. Additionally, discount rates and cash inflow estimates may not essentially for risk connected with the plan and may guess the highest achievable cash inflows over investment duration.
This may take place as a means of unnaturally increasing investor’s confidence, and such type of factors may need to be adjusted to explanation for unexpected costs or losses or for excessively optimistic cash inflow projection.
Payback period is one of the popular metric that is often used as an alternative to net present value. It is much simpler than NPV, mainly measuring the time required after an investment to recover the initial cost of the particular investment. Moreover, the payback period is strictly limited to the amount of time required to earn back initial cost of investment.