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16 Cards in this Set
- Front
- Back
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Payback Period |
This is the time required for the cash inflows from a capital requirement investment project to equal outflows.
The usual decision is to accept projects with the shortest payback period.Payback occurs when cumulative cashflow = $0. .
period.Payback occurs when cumulative cashflow = $0. Payback occurs when cumulative cashflow = $0. Payback occurs when cumulative cashflow = $0. |
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Advantages of Payback Period |
* Simple to compute and easy to understand.
* Its is more objectively based because it uses project cashs flows rather than accounting profits.
* It favours quick return projects which may produce faster growth for the firm and enhance liquidity.
* Choosing projects which payback is quickest will tend to minimize time relayed risks ( such as the time value of money). However, not all risks are related to time.
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Disadvantages of Payback Period |
* Payback period is a rough measure of liquidity not overall worth that is, it does not take into account monies received after the payback period.
* Payback period provides only a crude measure of the timing of project cash inflows that bus two projects may have the same payback period although they have different patterns of cash inflows; one may make aore immediate improvement in the forms liquid position than the other
It does not take into account the time value of money * It does not take into account the time value of money* It ignores the life expectancy of the project.
* It ignores the life expectancy of the project.
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Accounting Rate of Return (ARR) |
This can be defined as the ratio of average profits, after depreciation, to the average capital invested.
The usual decision is to choose projects with the highest ARR i.e. ARR above the cost of capital |
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Advantages of ARR |
* It is simple to calculate * Easy to understand * Management can compare the expected profitability of the business |
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Disadvantages of ARR |
* ARR is based on the " average annual profit" which may not be typical of any year.
* The timing of the cash inflows and outflows is ignored
*ARR does not show whether, or how soon, the net receipt will cover the initial outlay.
* ARR ignores risk factors
*ARR ignores the time value of money
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Discounted Cash Flow Techniques |
These all take into accoutnghe time value of money.
As therewl were uncertainties with the payback period and the accounting rate of return were becoming more and more evident people began to deach for methods of evaluating projects which takes into account the time value of money, this leads to the development of discounting cash flow techniques such as Net Present Value , Internal Rate of Return and Discounted Payback. |
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How is ARR calculated?
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ARR = Average profit / Capital invested * 100 |
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Net Present Value (NPV) |
It is found by discounting the future cash flows at the predetermined discount rate ( cost of capital) and the sum of the present value is compared with the cost of the investment
This method assumes some minimum desire rate of return or cost of capital ( hurdle rate) to the firm.
If the difference between the present value of the cash flows and the cost of the investment is positive, the project is desirable because its returns exceed the desired minimum.
If the difference is negative, the project is undesirable and should not be accepted. |
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Advantages of NPV |
* Net present value can always be calculated in a straightforward manner, unlike IRR which is more tedious
* It considers the time value of money
*It recognises income over the whole life of the project.
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Disadvantages of NPV |
* It holds less appeal for the man in the street who foes not understand discounting
* Present value tables are nor always readily available |
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Internal Rate of Return |
The IRR or yield, is the Tue interest rate earned on a project.
It is given by by hat interest which, when applied to the future cash flows , reduces the NPV of the project to zero.
is acceptable or not by comparing the calculated IRR with the cost of capital . The IRR is used to determine whether a project is acceptable or not by comparing the calculated IRR with the cost of capital . If the IRR > the cost capital, the project is acceptable.If IRR< the cost capital, the project is unacceptable
project is acceptable or not by comparing the calculated IRR with the cost of capital . If the IRR > the cost capital, the project is acceptable.If IRR< the cost capital, the project is unacceptable If the IRR > the cost capital, the project is acceptable.
If IRR< the cost capital, the project is unacceptable |
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Advantages of IRR |
* It recognizes the time value of money
* It recognizes income over the whole life of the project
* It is expressed as a percentage return which facilitates ranking among alternative projects
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Disadvantage of IRR |
* It assumes that earnings are reinvested at the internal Raye of return which may not be the prevailing rate at that point in time
* Spreadsheets for calculating IRR may not always be available and it may be necessary to use manual calculation
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How to calculate IRR |
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Discounted Payback |
The discounted payback method is an improved version of the payback method which takes into account the time value of money . The annual cash flow is discounted at the required Raye of return before the payback period is calculated. |
