Excess of Net Present Value

Excess of Net Present Value

Another type of discounted cash-flow approach to capital budgeting is the excess of net present value method. In contrasts to the internal rate of return, the net present value method assumes a target or a minimum desired rate of return (or the so called cut off rate). below which a proposal would be rejected by the management as undesirable in the light of the profit goals. Thus, in this method, (a) cash inflows, (b) initial investment, and (c) desired rate of return are given. All expected cash flows are discounted to the present. Using this minimum desired rate. If the result i.e., difference between the present value of future cash-flows and the initial investment, is positive, the project is desirable because its return exceeds the desired minimum. If the result is negative, the project is undesirable.

Excess Present Value Index: Excess present value index sometimes also called the profitability index is (or further step in the refinement of the excess/net present value approach. If reflects the percentage relationship between the present value of the future cash inflows at the desired rate of return and the initial investment.

I.PV Index = Present Value of cash savings/inflows(v)/Initial Investment× 10C

Thus, greater the  ratio (or EPV Index). the more profitable is the project. Moreover, the main advantage of the project. Moreover, the main advantage of the use of EPV index is the ready comparability between investment proposals of different magnitudes.