NPV There Are a Few Conceivable Reasons

NPV

There are a few conceivable reasons why decision-making methods other than net present value have been used by practitioners. The appeal of payback period is that it is easy to understand, for example. For small businesses especially, if there is no finance professional, the concepts in net present value might be too complicated, so payback period is used for simplicity. Another technique is IRR, which is no more or less complicated than NPV. Simplicity does not account for using IRR ahead of NPV, and there is little rational reason why it would be chosen. Because NPV addresses the raw amount of cash flow to the company, it is the better measure in those instances where the IRR and NPV conflict on mutually exclusive projects (Silber, n.d.).

The issue of uncertainty is addressed in two ways. The first is through the discount rate, which reflects the risk inherent in the project. The discount rate is usually based on the opportunity cost of capital, but may be adjusted if the risk associated with the project is higher than the risk associated with ongoing business. That is, if the future cash flows of the project have a higher degree of uncertainty than ongoing future cash flows. The other way to handle uncertainty is to conduct a sensitivity analysis. This tests different assumptions, to see how the results of the NPVcalculation respond to changes in the different sensitivity levels (Investopedia, 2012).

3. There are a number of qualitative issues that can be taken into account during the capital budgeting process. Different projects fit with the company's strategy in different ways, so there sometimes will be greater strategic considerations that are difficult to quantify. In addition, every cash flow will be based on qualitative assumptions. The manner in which these assumptions are quantified is critical to the quality of the capital budgeting analysis. In addition, the company's resources might be taken into consideration -- the company has to have the resources available to execute the strategy.

4. Risk is not the same thing as uncertainty, even though they are related concepts. Both are based on the same underlying concept of randomness, but the St. Louis Fed (2002) explains the differences between them. Risk is considered to be quantifiable randomness. Thus, risk is something that can be measured, for example a stock's beta, which is a risk measure based on past performance. Uncertainty is deemed to be unquantifiable randomness. So for a project, the costs might be subject to some risk because input costs can change, but the demand might be subject to uncertainty as well if the product has never been sold before. That would mean that there is no past history on which the company can draw its estimates -- they are uncertain where the costs are merely risky.