Net Present Value:
This is the method of capital budgeting that is considered better than pay back period technique and rate of return technique for evaluating the investment proposals or assets of various companies. In NPV method, we compute net present value of cash flows after removing present value of cash outflows from present value of cash inflows. This NPV is computed for each investment project. Only that investment project is acknowledged whose total present value will be high. Now, you can recognize what this technique is. In this technique, I have utilized the term present value. Devoid of knowing present value, you can’t compute net present value.
Definition of Present Value:
The Present value means today value of one dollar. This is as well value of money. Given money is one dollar. It might possible that the value of one dollar might increase after one year as:
A. Receiving of Interest on 1 dollar for 1 year.B. The value of money might increase fluctuations in the foreign exchange.C. Value of money might rise due to deflation in the world market. D. Even in inflation, prices will raise and we require 2 dollar rather than one dollar for buying similar quantity. This means trend of value of money will forever be upward.
Therefore, today received one dollar is very significant than what we obtain tomorrow and due to this reason, we fix a discount rate. This is the rate that we like. At this rate, we want to invest our entire money. On this rate, we can compute present value of one dollar payable or receivable yearly from present value table.
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