Chapter 7— Net Present Value and Other Investment
Finance for managers
Chapter 7— Net Present Value and Other Investment
Question 1 : List the methods that a firm can use to evaluate a potential investment.
There are discounted and non-discounted cash-flow capital budgeting criteria to evaluate proposed investments. They are
1) Net present value: NPV is a discounted cash flow technique, which is the difference between an investment’s market value and its cost.
NPV = Present value of cash inflow- Present value of cash outflow
The investment should be accepted if the net present value is positive and rejected if it is negative.
2) Profitability index: PI is a discounted cash flow technique in which present value of an investment’s future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio.
PI = PV of cash inflows / PV of cash outflows
If PI is positive, it will be accepted otherwise reject.
3) Internal rate of return: IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0
If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected.
4) Payback period: Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from inflows. It is a non-discounted cash-flow technique.
5) Discounted payback period: The time required for the discounted future cash flow at the firm’s required rate of return of a project to recoup the initial outlay is called discounted payback period. An investment is accepted if its discounted payback period is less than prescribed number of years.
6) Accounting rate of return: ARR is a non-discounted cash flow method in which accounting information’s are used rather than cash flows.
ARR= (Average annual profit after tax/Average investment over the life of the project) * 100.
Chapter 7— Net Present Value and Other Investment
Question 1 : List the methods that a firm can use to evaluate a potential investment.
There are discounted and non-discounted cash-flow capital budgeting criteria to evaluate proposed investments. They are
1) Net present value: NPV is a discounted cash flow technique, which is the difference between an investment’s market value and its cost.
NPV = Present value of cash inflow- Present value of cash outflow
The investment should be accepted if the net present value is positive and rejected if it is negative.
2) Profitability index: PI is a discounted cash flow technique in which present value of an investment’s future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio.
PI = PV of cash inflows / PV of cash outflows
If PI is positive, it will be accepted otherwise reject.
3) Internal rate of return: IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0
If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected.
4) Payback period: Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from inflows. It is a non-discounted cash-flow technique.
5) Discounted payback period: The time required for the discounted future cash flow at the firm’s required rate of return of a project to recoup the initial outlay is called discounted payback period. An investment is accepted if its discounted payback period is less than prescribed number of years.
6) Accounting rate of return: ARR is a non-discounted cash flow method in which accounting information’s are used rather than cash flows.
ARR= (Average annual profit after tax/Average investment over the life of the project) * 100.