Companies invest in various capital projects as they pursue company goals. These projects include purchasing new vehicles in order to reduce costs, purchasing new equipment in order to offer new products or building a new facility in order to expand into a new market. Many companies use the net present value method to evaluate each capital project. The net present value method presents advantages and disadvantages to the company.
Advantages of using the net present value method are that it considers the time value of money and allows investors to compare projects so they can make better decisions. Disadvantages are that it requires more complex calculations and uses assumptions that may not be realizable.
Advantage: Time Value of Money
One advantage of the net present value method involves its consideration of the time value of money. The value of money changes over time, especially during periods of high inflation or deflation. A company cannot rely on money being worth the same amount in the future as it is today. The net present value method allows the company to consider the value of the money on the day the company pays it out and the value of the money on the day the company receives it.
Advantage: Ranking Capability
Another advantage of the net present value method considers its ability to compare projects. As the company evaluates each project, it calculates the current total value of the project. This calculation considers each of the expected cash receipts and cash payments and the value of the money at the time of the transaction. The project with the highest net present value is viewed as the one most likely to bring the highest value to the company. The company may then pursue those projects that bring the most value to the organization.
Disadvantage: Complex Calculations
A disadvantage of the net present value method is that it requires the company to perform more complex calculations. The company needs to estimate each cash transaction that will occur with the project. The company uses numeric tables that provide multipliers for various time periods and interest rates. The company must locate the correct multiplier for each cash transaction and multiply the cash amount by the multiplier. Once the company performs each of these calculations, it adds up the total to determine the net present value of the project.
Another disadvantage of this method involves its use of assumptions. The company needs to make assumptions regarding both the dollar amount and timing of future cash transactions associated with the project. The company also needs to estimate its interest rate for the duration of the project. These assumptions may or may not be realizable. Inaccurate assumptions lead to inaccurate calculations of the net present value for a project.