ACC201-Introduction to Applied Finance
I will be analysing your three investment choices using three criteria, the net present value and internal rate of return and payback period. In analysing the following investments I have not taken into account the effects of taxation
Ranking of investments
Investment 3 has the best rating using the three analysis tools, the initial investment is paid back after 5.05 years, followed by investment 2
Limitations of analysis using NPV, IRR and PP
The results given from Net present value are affected by the discount rate and we have to assume that the rate will be the same over the life of the investment, however in reality the costs of money and thus discount rate can change monthly and it is unrealistic to assume that the discount rate will remain the same over the investment life
The internal rate of return does not factor in inflation or when applicable the costs of borrowing money in the rate it gives thus it is a higher rate than it should be as it ignores other costs.
Payback period does not put any value on returns after the initial investment is recouped, it also does not consider any additional outgoings.
Which investment should be chosen?
When selecting which investment risk has to be considered as well as what the other options are. Investment 1 and 2 carry virtually the same level of risk so comparing them is relatively simple just look at the numbers, when looking at the rankings investment 2 clearly outperforms investment 1. When comparing investment 3 to the other investments it is not so straightforward as returns cannot be certain and there are a lot of variables that will affect the return. Investment 2 and 3 both give the required rate of return it is up to you the investor to choose from an adequate return with low risk or a higher return with high risk.
Risks involved in each investment
Investment 1, Inflation is the major risk of this...
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