A Critical Evaluation of Three Basic Methods of Evaluating an Investment (Irr, Payback and Npv).
Prepare a critical evaluation of three basic methods of evaluating an investment (IRR, Payback and NPV).
There are several basic methods of evaluating an investments that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for the restrictive purposes for which they are appropriate. With the availability of computer based analysis and commercial software, it takes only a few seconds to compute these profit measures. However, it is important to define these measures precisely.
The internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a certain project equal to zero. This in essence means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or investment) equals its current market value. The higher a project’s internal rate of return, the more desirable it is to undertake the project. As a result, it is used to rank several prospective projects a firm is considering. As such the internal rate of return provides a simple hurdle, whereby any project should be avoided if the cost of capital exceeds this rate. A simple decision making criteria can be to accept a project if its internal rate of return exceeds the cost of capital and rejected if the IRR is less than the cost of capital. Although it should be noted that the use of IRR could result in a number of
There are several basic methods of evaluating an investments that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for the restrictive purposes for which they are appropriate. With the availability of computer based analysis and commercial software, it takes only a few seconds to compute these profit measures. However, it is important to define these measures precisely.
The internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a certain project equal to zero. This in essence means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or investment) equals its current market value. The higher a project’s internal rate of return, the more desirable it is to undertake the project. As a result, it is used to rank several prospective projects a firm is considering. As such the internal rate of return provides a simple hurdle, whereby any project should be avoided if the cost of capital exceeds this rate. A simple decision making criteria can be to accept a project if its internal rate of return exceeds the cost of capital and rejected if the IRR is less than the cost of capital. Although it should be noted that the use of IRR could result in a number of