When it comes to evaluating the feasibility of a project, the best method to use is the Net Present Value [NPV]. The NPV is the sum of the present value of future cash inflows from a project, minus the present value of the initial costs of the project investment. Mathematically, it is expressed as :
NPV = Cash Flow / (1 + i) ^ t - Initial Investment
Like all capital investment evaluation methods, the NPV is not 100% perfect. Let us examine the benefits and drawbacks of using the NPV method.
Advantages
1] Considers the time value of money – Consistent with the goal of maximizing wealth, the NPV method takes into consideration all relevant cash flows and its present value. This ensures that you are making the most accurate decision by at least considering how inflation will impact the net wealth created by the project investment.
2] Uses a rate of interest or discount rate that considers the return on investments – With the NPV technique, the interest rate used will reflect the cost of borrowing capital for a business or it may reflect the minimum rate of return required for a similar investment. Using different interest rates for multiple scenario forecasts will help you evaluate if the project will break even or not and also help you to figure out the ideal circumstance for embarking on a specific project.
3] Easy to understand – The NPV formula returns a single, absolute value number which represents the predicted value of wealth either created or destroyed by the project. The simplicity of this technique makes it easy to use to evaluate most project’s feasibility.
4] Easy to calculate on a spreadsheet – The NPV calculation can be performed on a spreadsheet if the cash flows and interest rate is known. With spreadsheets, you can compare the NPV of multiple projects. You can also substitute different numbers into your input cells to determine how much money will be generated under specific scenarios.
