The problems and the inaccuracies of the “Net Present Value” method are not really much of a secret among Accounting & Finance professionals, but that knowledge by itself doesn’t solve the situation. At the end of the day, those professionals still need to have their work done. So, in practice, the prevailing method to do “Investment Plan Evaluation” and Budgeting is the following:
Thru a spreadsheet, numbers for forecasted income and for forecasted expenses are being registered in distinct columns. The obvious action is to say that:
Income – Expenses = Profit
That equation is fundamentally correct from an Accounting point of view. Let’s not linger a lot on the need to calculate the “valuation of residual stocks of goods at Fiscal Year end” and other things, as these are considerations that eventually (one way or another) can be done. However, there are two missing numbers from that equation that need to be calculated and then incorporated into the result. They are the values for “Interest Income” and “Interest Expense”.
In order to calculate those two last numbers, we must create the simulation of the Bank account, or to call it thru other names the “Cash Budget” or the CashFlow. For that purpose, all sales, purchases, expenses etc are being turned into CashFlow projections.
For example: Forecasted Sales of March 2011 of 10 mil EUR plus VAT 23% and 60 days of credit to the customer, result in Bank collections on May 2011 of 12.3 mil EUR.
In that way, the Bank simulation gets populated by the forecasts. The result of this is that in the end we can say:
+ Collections of May
– Payments of May
+ Average Bank Account balance of April
= Average Bank Account Balance of May”
Interest is being calculated on a monthly total figure, on the basis of the monthly average balance of the Bank account.
Stick around, and we are going to see the problems that this method has, and why the “Net Present Value” method, even though it is one step in front of it in evolution terms, it delivers an inferior result.