Net Present Value (NPV) or Net Profit Criterion - Working Capital Management

NPV or net profit criterion: it has been noted above that working capital management like other financial decision of the firm is agreed to maximization of shareholders wealth and involves risk-return trade-off.

NPV (Net Present Value) is the basic rule of financing decision making, particularly long investment decisions does NPV hold valid for working capital decisions also which are essentially short term in nature.

Theoretically, the same general rules namely NPV, developed for the firm’s investment decision would apply to investment in current assets. But in practice, in view of certain unique characteristics of current asset via inter-relatedness, volatility and reversibility, the net present value is rarely used in practice. There are two many alternatives that must be evaluated in view of the continually changing level of current assets visà- vis operations of the firm. Net present values are not only somewhat difficult to calculate but also interpret for current assets. Some modifications of NPV, which reflect the unique characteristics of current assets and liabilities, may thus be used. Two useful modifications of NPV which can be readily, followed as decision criteria in working capital decision are average net profit per period and total cost.

In general, the present value of an amount A to be received in N periods, hence at the rate of r per period will be = A/(I + r)n and NPV = Co + (C1/ I + r), where Co stands for initial cash outlay C; for cash to be received from the investment in one year’s time and r for the rate of interest. For example, if we are investing N5000 and will continue to receive N5000 per year so long as we keep the N5000 invested, the net present value (NPV) of the above investment at a discount rate of 8 percent can be computed as follows:

NPV

discount-of-8-percent

We may also calculate an annuity that has present value equal to the net present value of the above investment. Interestingly, the annuity is the average net profit per period from the investment as may be seen from the following:

average-net-profit-per-period

Thus, N400 is the annual capital cost of N5,000 invested at an 8% rate of interest and the annual net profit of N100 does not depend on when the investment is reversed. The result is that we can use net profit per period as a criterion for choosing among alternative reversible investments.

The investment with the highest value of net profit per period is also the investment with the highest net present value, regardless of when the investment is reversed. Investment with positive NPV’s will have positive net profits, investments with zero NPV’s will have zero net profits and investments with negative NPV’s will have negative net profit.

This net profit per period instead of NPV, can be used as a decision criterion for working capital management.

Many current assets decisions particularly inventory decisions can be made on the basis of minimizing cost. There is also instead of minimizing the net present value of costs, one may minimize total annual cost where the annual capital cost of the investment is the discount rate times the amount invested. In sum, the current policies may be selected that maximizes its profit or minimizes its total cost per period. The choice between the profit or cost criterion will, of course, depend on the particular problem being analyzed.


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