According to Fernando(2023), the computational steps of a Net Present Value
(NPV) calculation involve the following:
1. Defining NPV: NPV is the sum of the present values of cash inflows and
outflows.
2. Discounting Cash Flows: Because of the time value of money, cash inflows
and outflows can only be compared at the same point in time. NPV discounts
each inflow and outflow to the present, using a discount rate, to make them
comparable.
3. Calculation: The NPV is calculated by summing the present values of each
individual cash flow using the formula:
NPV = PVInflows - PVOutflows
Where PVInflows are the present values of cash inflows, and PVOutflows are
the present values of cash outflows. Cash inflows are typically positive, while
cash outflows are negative.
4. Interpreting NPV:
- A positive NPV means the investment is worthwhile, as the value of the
inflows exceeds the outflows.
- NPV equal to 0 means the inflows equal the outflows, indicating no gain or
loss.
- A negative NPV means the investment is not good, as the outflows exceed
the inflows.
5. Decision Making: Management uses the NPV to make decisions about
projects. In theory, they should invest in projects with a positive NPV, as these
projects add value to the firm. However, in practice, the decision also
depends on other factors, and the accuracy of the inputs (discount rate, cash
flow estimates) can impact the decision-making process.
6. Advantages of NPV: NPV is easy to use, allows for easy comparison of
investment options, and can be customized by adjusting the discount rate to
reflect various factors like risk.
7. Disadvantages of NPV: NPV relies on estimates and may not fully account
for opportunity costs. It also does not provide a complete picture of an