The Net Present Value (NPV) method of evaluating a long-term capital project involves obtaining the project’s net cash flows. To get this value, the project’s future expected cash inflows are discounted by an appropriate discounting rate then summed together. The project’s cash outflows are then subtracted from the sum total of cash inflows. A positive result, NPV, insinuates a viable project while a negative NPV insinuates an inviable project (Gallo n.p.). As such, the corporation should undertake the long-term capital project if the NPV is greater than zero. It is recommendable to use the NPV method in conjunction with other methods such as the payback period especially when one is interested in identifying the viability of the project and the break-even period.
The payback period approach of evaluating a project determines the amount of time it would take to recover the capital outlay for the project in years. The payback period is based on a pre-set acceptable period. The criteria to be followed under this approach is to accept the project if its calculated payback period is less than the pre-set acceptable period (Ehrhardt, Michael & Eugene 337). If the calculated period happens to be more than the set acceptable period then the project is rejected. The payback period has two serious flaws: it ignores the time value of money and the cash inflows that will be realized after the period of consideration. As such, using this method in isolation may lead to poor decisions. It is highly recommendable that analysts supplement the payback period with the NPV approach. The reason being the latter considers all cash inflows until the project is rendered obsolete. Secondly, the NPV method considers the time value of money by discounting the cash inflows by a suitable discounting factor.
Ehrhardt, Michael C., and Eugene F. Brigham. Corporate finance: A focused approach. Cengage Learning, 2016.
Gallo, Amy. “A Refresher on Net Present Value.” Harvard Business Review, 6 Dec. 2017, hbr.org/2014/11/a-refresher-on-net-present-value.