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Here I take a quick look at each one and the pro’s of con’s of using these metrics. Description – Perhaps the mostly widely used technique for analyzing a potential investment opportunity or project is the net present value of cash flow or NPV approach. Using the NPV of cash flow technique we would discount all cash flows in our business case at the opportunity cost of capital – in most cases the weighted average cost of capital for a company. Pros – Accounts for the fact that the value of a dollar today is more than the value of a dollar received a year from now – that’s the time value of money concept. Cons – Does not give visibility into how long a project will take to generate a positive NPV due to the calculations simplicity.
Our NPV rule tells us to accept all investments where the NPV is greater than zero. However, the measure doesn’t tell us when a positive NPV is achieved. Does it happen in five years or 15? Another limitation of the NPV approach is that the model assumes that capital is abundant – that is there is no capital rationing.