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One of the key areas of long-term decision-making that firms must tackle is that of investment the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.
- The Importance of investment appraisal methods.
- They extend the quality of administrative decisions.
- In the help of these capable processes, firm's expenditures are prepared in hope of understand future profit.
- The expenditure and the credible recoupment of investment can be compared and considered.
- We can obtain an idea of achievement or failure of the firm.
- A long- term bad impact is arisen on the firm's investment because of the wrongly-made decision.
- They connect the responsibility of significant sums of money and influence the complete conduct of the business for various future years.
- The rate of return that is essential by investors can be integrated by converting future cash flows to their current values.
Payback period is the length of time required to cover the first cost of capital of an investment the periodic net cash flow generated by that investment. Pay back Payback period is the number of years required to recover the cost of project or initial cash out flows. Say a project requires an initial investment of $10,000 and you can expect cash inflows at the end of each of the next four years in amounts of $5,000 $4,000 $3,000 and $1,000. Payback period is the oldest of the measures used for project evaluation in Capital Budgeting. A variation of payback period titled discounted payback period takes in to consideration the time value of money.Criticisms of payback period
The most important criticisms of payback period are, it ignore time value of money furthermore it completely ignores cash inflows after the payback period. This method does not evaluate profitability of project. It insists only on improvement of the cost of the project. And it does not evaluate the rate of return.
This system is used only when the rate of return on investment is determined by the management. Under this method present value of all cash inflows are compared against the present value of all cash outflow.
The Net present value method has to consider as the time value of money, NPV also regard as the cash flow stream over the overall life of the project. Furthermore it focuses awareness on the purpose of the maximization of the wealth of the firm. This method is more suitable when cash inflows are not uniform and it focuses attention on the objective of maximization of wealth of the firm.
If cost of capital increased, the net present value of the project will be decreased. On the other hand, if the cost of capital decreased, the net present value will be increased. For example: in project A, if cost of capital change from 12 to 15 percentages, the net present value will decrease from 31740 to19790. On the other hand if cost of capital change from 12 to 10 percentages, the net present value will increase to 38520 from 31730.
Internal Rate of Return is an investment appraisal method; it does not indicate the rate of return of the project. In order to find out the rate of return of a project, approximate net cash inflows of each year are discounted at various rate till a rate is obtained at which the present value of cash inflow is equal to the initial investment or the net present value become zero. This rate is also called as internal rate of return.Calculations of Internal Rate of Return
As discount cost of capital increases, there is a decrease in the net present value as well. While decreasing furthermore, it will come to zero and that will represent the internal rate of return.
When we compare these two techniques of investment appraisal, the net present value is considered to be superior because of the following reasons,
- The Net Present value of different project can be added. But the Internal Rate of different project cannot be added.
- Net present value is calculated in terms of currency while internal rate of return is expressed in terms of percentage return a firm expects the capital project to return.
- Net present value method calculates the additional wealth, while internal rate of return method does not calculate the additional wealth.
- The internal rate of return can't be used to evaluate the projects where there are changing cash flows.
- Applying net present value using different discount rates will results in different recommendations, while internal rate of return method always gives the same recommendation.
- Internal rate of Return method provides different rates for different proposals, while reinvestment rate for each proposal is the same in Net Present Value method.
- The use of the internal rate of return method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash in future.
- The Internal Rate of Return method can't work properly if it is comparing two mutually exclusive investment projects of different size or scope.
From the above mentioned methods and examples we can conclude that investment appraisal is the process of analyzing alternative proposals and helps in making decision during various situations in business. It is very useful in analyzing business in various point of time. Mainly used in long term projects usually, and hence the funds can be invested in right organization at right time with a guarantee of making profit.