Question
Discuss the Net Present Value (NPV) method for evaluating capital budgeting decisions.
How does NPV differ from the Internal Rate of Return (IRR)? Explain with suitable
Answer :
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The Net Present Value (NPV) method is one of the most important techniques used in capital budgeting to evaluate the financial attractiveness of long-term investment projects. It is based on the principle that the value of money changes over time; therefore, future cash flows must be converted into their present values before comparing them with the initial investment. NPV measures the net increase or decrease in the wealth of the firm resulting from an investment decision. NPV is calculated by finding the present value of all expected future cash inflows and outflows and deducting the initial investment. The general formula is: NPV = Present Value of Cash Inflows − Initial Investment The present value of each future cash flow is calculated using the firm's required rate of return or cost of capital as the discount rate. If a project has an initial investment of ₹5,00,000 and the present value of its expected future cash inflows is ₹6,00,000, its NPV will be ₹1,00,000. This indicates that the project is expected to add ₹1,00,000 to the firm's value. The NPV decision rule is straightforward. A project should be accepted when its NPV is positive because it
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