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On the other hand, the Swifty Feet sneaker is a novel design, and the sales staff has no idea how many pairs they can sell. They think it will be a hot item, but they can't give any confident projections of sales. However, this means that the product line of Hasty Rabbit will still rely on only one product, the Blazing Hare.
And the CEO has already stated that he wants more diversification because it's too risky to have only one product in the rapidly changing sneaker market. The CFO will need to go to the bank and borrow this amount of money.
Net present value
The comparison of these two projects points out the advantages and disadvantages of using the net present value method. It does give some initial insights about the financial feasibility of different projects, but often, other qualitative factors exist that must be considered. James Woodruff has been a management consultant to more than 1, small businesses.
As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work. Skip to main content. Since the cash inflows are uneven, the NPV formula is broken out by individual cash flows.
Net present value - Wikipedia
Because each period produces equal revenues, the first formula above can be used. Both projects require the same initial investment, but Project X generates more total income than Project Y. However, Project Y has a higher NPV because income is generated faster meaning the discount rate has a smaller effect.
Net present value discounts all the future cash flows from a project and subtracts its required investment. The analysis is used in capital budgeting to determine if a project should be undertaken when compared to alternative uses of capital or other projects.
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Reinvestment assumption does not affect NPV. NPV is theoretically sound because it has realistic reinvestment assumption.
It considers the cost of capital and provides a dollar value estimate of value added, which is easier to understand. Another particularly important feature of NPV analysis is its ability to notch the discount rate up and down to allow for different risk level of projects. However, NPV is dependent on the size of the project.
Without careful analysis, an investor might select a high NPV project ignoring the fact that many smaller NPV projects could be completed with the same investment resulting in higher aggregate NPV. It requires careful analysis in capital rationing. The size of project is irrelevant for IRR. This feature makes it a good complement to NPV. IRR is also easier to calculate because it does not need estimation of cost of capital or hurdle rate.
It just requires the initial investment and cash flows. However, this same convenience can become a disadvantage if we accept projects without comparison to cost of capital.