Business Finance

Topics: Net present value, Internal rate of return, Discounted cash flow Pages: 4 (1349 words) Published: May 6, 2013
Business Finance
Q: Please compare the advantages and disadvantages of the following investment rules: Net Present Value (NPV), Payback Period, Discounted Payback Period, Internal Rate of Return (IRR) and Profitability Index (PI). (You can start by considering the following questions for each investment rule: Does it use cash flows or accounting earnings? Does it consider all cash flows or not? Does it apply a proper discount rate? Whether the acceptance criteria are clear and reasonable? In what situation it can be applied? What kind of weakness does it have?) (10 points)

A: Net Present Value is a method to evaluate a project value. NPV requires an estimate of the cost of capital. Therefore, to understand what is NPV, Discount rate should be completely understand. The first advantage is that NPV gives important to the time value of money. Secondly, in the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered. Thirdly, profitability and risk of the projects are given high priority. Fourth, NPV helps in maximizing the firm's value. On contrary, NPV is difficult to use. Also, NPV cannot give accurate decision if the amount of investment of mutually exclusive projects are not equal. One difficulty would be calculation of appropriate discount rate. Meanwhile, NPV may not give correct decision when the projects are of unequal life. It could be applied in the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once...
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