There are several calculation methods that allow companies to determine if an investment will be profitable. Capital budgeting is an essential process for companies during which the management evaluates investment opportunities. There are several situations in which the process would rely completely on the net present value (NPV) of a project. This tool can be useful for projects with an identical lifespan. NPV incorporates “cash flow, the timespan of a project, and the weighted average cost of capital” (Carlson, 2018, para. 3). Thus, this approach helps evaluate the potential assets of a specific project and determine whether it is a good investment option.
The specifics of NPV suggest that a company can rely on this tool when analyzing large-scope projects that require substantial investments. Companies use an evaluation of potential cash flow combined with the present value of the investment to calculate NPV. Since NPV relies on estimations for future expenditures and profits, companies can rely on this method when they possess enough data that can be used to substantiate these estimations.
A potential reason that can result in a higher NPV is that the project generates a more significant return than was initially anticipated. Since NPV above 0 is an indicator that the project investment is a valid option for the business, it is possible that the expected profitability will exceed the anticipated (Brigham & Ehrhardt, 2017). It is mainly because NPV relies on today’s value of the expected cash flows, which is an estimation and can differ in actuality. Hence, a higher NPV suggests that the project was underestimated upon initial evaluation. In general, NPV is an insightful evaluation tool that can help companies determine if they should invest in a project or not.
References
Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory and practice [with MindTap] (15th ed.). Mason, OH: South-Western.
Carlson, R. (2018). Net present value (NPV) as a capital budgeting method.