INVESTMENT APPRAISAL TECHNIQUES: BENEFITS AND LIMITATIONS
Being the maximisation of market value the fundamental goal of every firm, selecting investment projects is a crucial decision to the firm: failing to identify projects whose return is greater than the cost of capital invested not only represents an opportunity cost but can also lead to a loss of market power compared to that of the competitors, which in turn negatively affect the ability to generate profit. For this reason, the choice of a project must be based on a thorough financial evaluation, which is possible by employing adequate investment appraisal techniques in order to evaluate the profitability of investment proposals.
Businesses mainly employ four investment appraisal techniques, which can be classified into two categories:
I. Discounted cash flows (DCF) techniques take into consideration the time value of money, based on the idea that money available now is worth more than the same amount of money available in the future, due to underlying earning potential. The DCF techniques are the Net Present Value (NPV) and the Internal Rate of Return (IRR);
The NPV method is regarded …show more content…
the sum of the beginning and ending book value of the project divided by two. The decision rule is to select those project whose ARR is greater than a target rate of return, called hurdle rate, whose value should be adjusted taking into account the risk of the project under study: the riskier the project, the higher the hurdle rate. Empirical research have shown that the ARR falls behind compared to other investment appraisal practices²,probably due to major drawbacks, such as assuming stable cash receipts over time, ignoring the length of the project, the time value of money and the size of the
Being the maximisation of market value the fundamental goal of every firm, selecting investment projects is a crucial decision to the firm: failing to identify projects whose return is greater than the cost of capital invested not only represents an opportunity cost but can also lead to a loss of market power compared to that of the competitors, which in turn negatively affect the ability to generate profit. For this reason, the choice of a project must be based on a thorough financial evaluation, which is possible by employing adequate investment appraisal techniques in order to evaluate the profitability of investment proposals.
Businesses mainly employ four investment appraisal techniques, which can be classified into two categories:
I. Discounted cash flows (DCF) techniques take into consideration the time value of money, based on the idea that money available now is worth more than the same amount of money available in the future, due to underlying earning potential. The DCF techniques are the Net Present Value (NPV) and the Internal Rate of Return (IRR);
The NPV method is regarded …show more content…
the sum of the beginning and ending book value of the project divided by two. The decision rule is to select those project whose ARR is greater than a target rate of return, called hurdle rate, whose value should be adjusted taking into account the risk of the project under study: the riskier the project, the higher the hurdle rate. Empirical research have shown that the ARR falls behind compared to other investment appraisal practices²,probably due to major drawbacks, such as assuming stable cash receipts over time, ignoring the length of the project, the time value of money and the size of the