Net Present Value

Net Present Value

Net present value (NVP) is the preferred budgeting valuation method for maximizing the return of invested funds. The reason is that it both deals with the actual dollar amounts involved and takes into account the opportunity cost of not investing those funds in other projects, investing them through more traditional means, or distributing them to the owners.

The internal rate of return, which calculates the discount rate required to make the net present value of the project zero, can lead to unwise capital budgeting decisions. Small projects might have higher rates of return but, when the returns are totaled, not bring as much profit to the company as one larger one. The internal rate of return also does not take into account the longevity of a project and the possibility of not finding other projects for future investment.

The payback period method, which is also quite popular, does not discount the future cash flows. Also it can report unfavorably on projects which require investment over time to reach their full potential. Finally, a quick return of capital does not guarantee that an equally beneficial opportunity to invest that capital will be available again in the near future.

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