Net Present Value Business Intelligence

The assumptions are that it is a perfect and efficient market and that all of the planes will be replaced and the options are mutually independent. All the cash flows are incurred at the end of the accounting year.

1. Strengths and Weaknesses

The strength of replacement decision that Red Baron has analyzed include:

Net Present Value

Net present value (NPV) is used to evaluate in this replacement decision. The NPV calculation requires calculating the difference between the project cost (cash outflows) and cash flows generated by that project (cash inflows). NPV determines the profitability of the project's projected future income. NPV is an effective tool in Capital Budgeting Replacement Decision because it uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future cash flows. Discounting those future cash flows to the present creates an apple to apples comparison between the cash flows. The difference provides you with the net present value. It is a good way to use NPV rule when the projects are mutually exclusive as it gives the direct profitability of each project by magnitude and is also consistent with the capital budgeting goal of shareholder wealth maximisation. In this case where the projects are mutually exclusive, the project with the highest and positive NPV should be accepted. He also takes into consideration the higher cost of capital, which adjusts the risk of introducing PJ-2 and PJ-3 to a certain degree.

However, he fails to consider that although NPV is an effective tool in Capital Budgeting, it also has its weaknesses. The first disadvantage is that NPV is only accurate