There are many different methods business owners use to efficiently analyze business investment. One of these effective methods is the calculation of the net present value or NPV. The second most effective method would be the calculations of the internal rate of return or IRR. There are also other useful methods as well, for example, the payback rule and the profitability index. Many business owners use the above procedures to help them in their decision making of acquiring other businesses.
“NVP is important to a project because if the cost of the investment is going to be, or is more than the revenue from that project, then it may be more cost effective to shut down the project all together rather than lose more money. If multiple projects are available, then it is wise to first calculate the NPV for each project, choose those that have a positive NPV, and reject the ones that have zero or negative NPVs. Moreover, the IRR method can be used, and generally, they should provide the same ranking of the projects because the projects with high NPV also tend to have high IRR (Hestwood, Lial, Hornsby, & McGinnis 2010)”.
“There are many reasons the IRR is imperative to a company. If the rate of return is insufficient, it means additional cash is out flowing from the company than is inflowing into the company. This could lead to negative working capital. The IRR is imperative for a company to understand, so if necessary, they can afford to finance more activity or if necessary, they then can invest additional money (Hestwood, Lial, Hornsby, & McGinnis 2010)”.
The formula used to calculate the PV is future value times (1/((1+i^n)) = present value. This calculation is useful in investment analysis to assess if an investment with a promised set amount of return in the future will give a net gain in the present value or will only appear to be increasing but containing the same or even less amount when time value of money is considered. For
References: Hestwood, D., Lial, M., Hornsby, J., & McGinnis, T. (2010). Quantitative reasoning for business. (custom e-text) Boston, MA: Pearson/Addison-Wesley. Sevilla, A., & Somers, K. (2007). Quantitative reasoning: Tools for today’s informed citizen (1st ed). Emeryville, CA: Key College Publishing.