Question

1. Investment Analysis Four methods often used by business planners for ranking. acceptimg. or rejecting various investment slternatives include () simple-rate-of-return, internal rate-of-return, etc (a) Name two other rethods. (b) Name two methods that are generally considered superior methods. (c) Explain why the two methods are superior?

Answer 1

a) 1. Net present value

2. Profitability Index

b) 1. Net Present Value

2. Internal Rate of return

c)

Net present value(NPV): It is one of the discounted cash flow methods. This is considered to be one of the best methods of evaluating the capital investment proposals. Under this method the cash inflows and outflows associated with each project are first calculated. It maybe noted that this method gives valid results only if money can be immediately reinvested at the chosen rate of interest.

Characteristics:

1. The NPV of simple project monotonically decreases as the discount rate increases. The decrease in NPV, however, is at decreasing rate.

2. The NPV method is based on the assumption that the intermediate cash inflows of the project are reinvested at the rate of return equal to the firm's cost of capital.

3. NPV method can be used to accept or reject the project. The project would be accepted as the NPV is positive and rejected if NPV is negative.

NPV>0 (accept)

NPV<0 (reject)

Internal Rate of return: IRR is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. In other words, it is that rate of return which equates the present value of cash inflows to the present value of cash outflows.

IRR is the maximum rate of interest which an organization can afford to pay on the capital invested in a project, a project is accepted if IRR exceeds the cut-off rate and rejected, if it is below the cut-off rate.

Implications of IRR:

1. Easy to understand

2. Considers the time value of money

3. It is more practical since IRR is expressed as a percentage, which is expected to earn more than the required rate of return.

Difference between NPV and IRR

1. The NPV takes the interest rate as the known factor while the IRR methods takes it as an unknown factor.

2. The NPV seeks to find out the amount that can be invested in a given project so that its anticipated earnings will exactly sufficient to repay this amount with interest at the market rate. On the other hand IRR method seeks to find the maximum rate of interest at which the funds invested in the project could be repaired out of the cash inflows arising out of that project.

3. Both NPV and IRR proceed on the assumption that cash inflows can be reinvested at the discounting rate in the new projects.

However, reinvestment of funds at the cut-off rate is more possible than at the internal rate of return. Hence, NPV is more reliable than IRR for ranking two or more capital investment projects