Describe Net Present Value Internal Rate of Return Payback P

Describe Net Present Value, Internal Rate of Return, Payback Period, Profitability Index and Average Accounting Return and the advantages and disadvantages of each. Why are there so many measures to determine if a project is worth undertaking?

Solution

There are various method of evaluating projects and decide which project is to undertake

Net Present value- In this Method time value of money is considerred. All the future cash outflows and inflows are discounted to the present date and compared with present out flow to see if the project is giving positive or negative value to the firm.

If  All the future cash outflows and inflows are discounted to the present date is higher present out flow it gives positive Net present value and if all the future cash outflows and inflows are discounted to the present date is lower present out flow it gives negative Net present value. We can choose project whcih gives positive NPV.

To find the presnet value , future cash inflows and outflows are discounted at the required rate of return

NPV= - Cash outflow today+ Cash inflow in T1/(1+r)+Cash inflow in T2/(1+r)^2+Cash inflow in T3/(1+r)^3 and so on

Advantages:-

1. It considers time value of money

2. It considers all the future cash out flow and inflow

3. It helps in finding if any project is adding value to the firm or not

Disadvantages-

1. Estimation of cash flow is difficult and can vary in reality

2. Estimation of discount rate is again not easy and even a small change in Discount rate can make the NPV cary

3. It does not deal with future uncertainty

Internal Rate of return:- This method is very much related to NPV. It is the rate of return which makes Net present value zero. It says if IRR is greator than required rate of return the project can be accepted and if IRR is lower than required rate of return the project will be rejected.

Zero=- - Cash outflow today+ Cash inflow in T1/(1+r)+Cash inflow in T2/(1+r)^2+Cash inflow in T3/(1+r)^3 and so on

Advantages:-

1. It considers time value of money

2. It considers all the future cash out flow and inflow

3. It is easier to interpret in percentage terms

Disadvantages-

1. It is lengthy and many times require Trail and error Method to calculate

2. It is not very much usefull in mutually exclusive projects

3. It gives Multiple IRR when the cashflows are non conventional

Payback Period - Under this method we find out how many years it ill take to recover all the cash initial outflows invested in a projects. There could be constant cash inflow or cash inflow might vary

Example- If $1000 is invested today . in Year 1 inflow is $300 then in Year 2 inflow is $600 thus in this example 2 year is pay back period

Advantage-

1. Simple and easy to calculate and undertand

2. It considers liquidity and prefers early recovery of investment

Disadvantages:-

1. It does not consider time value of money

2. It ignores cashflows after pay back period

3. It focus on capital recovery instead of Profitability

Profitabilty Index- It is also called benefit to cost ratio. It is ratio of present value of all the future cash flow to the initial cash outflow for any project.

A project can be accepted if PI is greator than 1 and will be rejected when PI is less than 1.

Advantages-

1. It considers time value of money

2. Better than NPV as it gives information in terms of Ratio

Disadvantages-

1. It is not suitable if any cash outflow is in future as it considers on initial cash outflow as cost

2. Estimation of cash flows could be difficult

3. Not usefull in mutually exclusive projects

Avergae Acconting return- It is defined as ratio of average after tax Profit to average investment. This method considers accounting profit instead of cash inflows.If ARR is higer than minimum rate established by company , project can be accepted and if ARR is lower than minium rate established by comany , Project will be rejected.

Advantage-

1. It is simple to use

2. it is based on Accounting information which is easily avaialble

Disadvantage:-

1. It considers accounting profit whcih can be adjusted in varius ways instead of actual cash inflowa

2 It does not consider time value of money

There are many measures to determine if project is worth undertaking or not as different projects require information and different pupose . Depending on the requirement the method will be used.

For example- For any project main concern is to recover investment at the earliest payback method is usefull. and for any other Project main concern is shareholders wealth maximization , NPV will be used.

Suppose for any project we caanot find the cash flow but accounting information is avaiable ARR will be used.