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 complexities such as a project with multiple IRRs or no IRR and also that IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate. Internal rate of return is the flip side of net present value (NPV), where NPV is discounted value of a stream of cash flows, generated from investment. IRR computes the break-even rate of return showing the discount rate.
IRR can be mathematically calculated using the following formula: C0+C11+r1+C21+r2+C31+r3+Cn1+rn=0
C0 – the Cash Outflow generated in period No= 0
C - the Cash Flow generated in the specific period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by employing trial and error method or use built-in functions from Excel. In addition to problems associated with calculating an IRR, there are a few issues with which the user should be aware. One of them, if the series of cash flows has more than one sign reversal (changes from a positive to a negative cash flow, or vice versa) then there are multiple solutions. For example, if we have two sign changes in the series of cash flows and thus we have two IRRs. In fact, there are as many roots (solutions) as there are changes in signs, so a problem with 4 sign reversals would have 4 different solutions. To deal with this issue, a modified internal rate of return, or MIRR, is often used. Under this approach, all negative cash flows are first treated as a single problem and placed into an equivalent negative single present value. Then, all positive cash flows are treated as a single problem and represented as a single positive future value. Finally, NPV methods are applied to the two values – the negative single initial value and the positive single future value as though these were the only two cash flows and therefore having only one solution. Advantages of internal rate of return (IRR)
* It is considered to be straight forward and easy to understand. * It recognizes the time value of...
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