Present Worth Analysis

Until the 1950s, the paycheck method* was widely used as a means of making investment decisions. As flows in this method were recognized, however, business people began to search for methods to improve project evaluations. This led to the development of discounted cash flow techniques (DCF), which take into account the time value of money. One of the DCFs is the net present worth method (NPW). A capital investment problem is essentially one of determining whether the anticipated cash inflows from a proposed project are sufficiently attractive to invest funds in the project. In developing the NPW criterion, we will use the concept of cash flow equivalence discussed in Section 17.2. Usually, the most convenient point at which to calculate the equivalent values is often time 0. Under the NPW criterion, the present worth of all cash inflows is compared against the present worth of all cash outflows that are associated with an investment project. The difference between the present worth of these cash flows, called the net present worth (NPW), determines whether or not the project is an acceptable investment. When two or more projects are under consideration. NPW analysis further allows us to select the best project by comparing their NPW figures.

We will first summarize the basic procedure for applying the present worth criterion to a typical investment project.

• Determine the interest rate that the firm wishes to earn on its investments. This represents an interest rate at which the firm can always invest the money in its investment pool. We often refer to this interest rate as either a required rate of return or a minimum attractive rate of return (MARR). Usually this selection will be a policy decision by top management. It is possible for the MARR to change over the life of a project, but for now we will use a single rate of interest in calculating NPW.

• Estimate the service life of the project.**

• Determine the net cash flows (net cash flow = cash inflow - cash outflow).

• Find the present worth of each net cash flow at the MARR. Add up these present worth figures; their sum is defined as the project's NPW.

• Here, a positive NPW means the equivalent worth of inflows are greater than the equivalent worth of outflows, so project makes a profit. Therefore, if the PW(i) is positive for a single project, the project should be accepted; if negative, it should be rejected. The decision rule is

If PW(i) > 0, accept the investment If PW(i') = 0, remain indifferent If PW(i) < 0, reject the investment

Note that the decision rule is for a single project evaluation where you can estimate the revenues as well as costs associated with the project. As you will find later, when you are comparing alternatives with

* One of the primary concerns of most business people is whether and when the money invested in a project can be recovered. The payback method screens projects on the basis of how long it takes for net receipts to equal investment outlays. A common standard used in determining whether or not to pursue a project is that no project may be considered unless its payback period is shorter than some specified period of time. If the payback period is within the acceptable range, a formal project evaluation (such as the present worth analysis) may begin. It is important to remember that payback screening is not an end itself, but rather a method of screening out certain obvious unacceptable investment alternatives before progressing to an analysis of potentially acceptable ones. But the much-used payback method of equipment screening has a number of serious drawbacks. The principal objection to the payback method is its failure to measure profitability; that is, there is no "profit" made during the payback period. Simply measuring how long it will take to recover the initial investment outlay contributes little to gauging the earning power of a project.

the same revenues, you can compare them based on the cost only. In this situation (because you are minimizing costs, rather than maximizing profits), you should accept the project that results in smallest, or least negative, NPW.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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