ACC501 Business Finance GDB 2 Solution Feb 18 2015

Discussion Question:

If NPV is considered as the best technique for capital budgeting, why do the financial analysts use other measures? Discuss with conceptual rationale.

Solution:

  • NPV is based on future cash flows and the discount rate, both of which are hard to estimate with 100% accuracy.
  • There is an opportunity cost to making an investment which is not built into the NPV calculation.
  • Other metrics, such as internal rate of return, are needed to full determine the gain or loss of an investment.

The first disadvantage is that NPV is only as accurate as the inputted information. It requires that the investor know the exact discount rate, the size of each cash flow, and when each cash flow will occur. Often, this is impossible to determine. For example, when developing a new product, such as a new medicine, the NPV is based on estimates of costs and revenues . The cost of developing the drug is unknown and the revenues from the sale of the drug can be hard to estimate, especially many years in the future.

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