Question

Write in your own words Define the payback, net present value, internal rate of return, and profitability index methods.

Need 300 words discussion

Don't rewrite already existing chegg answer

Answer 1

Payback

Payback period in the capital budgeting area means the time required to recover the funds which are expended in an investment, or to reach the break-even point.

For our example,

An 1000 investment made at the beginning of year 1 which will return 500 at the end of year 1 and year 2 respectively will have the two-year payback period.

Payback period is generally expressed in years. It is accumulate by year till the Cumulative Cash Flow is a positive number: that year is the payback year.

A simplified cash flow model which shows the payback period as the time from the project completion to break-even. The payback period should be also calculated from the beginning of the project.

The time value of money is not considered into the account. Payback period measures that how long will something takes to "pay for itself." Everything else being equal, lower payback periods are preferable to higher payback periods.

Net present value

Net present value is known as the difference between the present value of cash inflows and cash outflows over the period of time. It is also used in capital budgeting and the investment planning to analyze the profitability of the projected investment /project.

A positive net present value shows that projected earnings generated by the project /investment - in present amount – which exceeds the anticipated costs. It is presumed that the investment with a positive NPV will known to be profitable, and the investment with a negatives NPV will result in the net loss.

internal rate of return

The internal rate of return is the metric which is used in the capital budgeting to estimate the profitability of the potential investments and the IRR is a discount rate that will make the net present value of all the cash flows from a particular investment = zero. IRR calculations will relies on the same formula as the NPV does.

To compute IRR using the formula, one would deem NPV equal to zero and then solve for the discount rate, which is the IRR. Because of this type of the nature of this formula the IRR should not be calculated analytically and must the be calculated through the trial and-error or using the programme to compute IRR.

Usually, the higher the project's internal rate of return, then the more desirable it is to consider. The IRR is considered uniform for investments of varying types IRR could be used to rank the multiple projects on a the relative basis. Assuming that the costs of the investment were same among the various projects, the projects with the most IRR would probably be considered the best and should be considered first.

profitability index

The profitability index is the index which attempts to identify the relationship among the costs and the benefits of a proposed investment through the a ratio compute as

PV of future cash flows /Initial investment

Profitability index is known as an appraisal technique which is applied to potential capital investment. This technique divides the projected capital inflow by the projected capital outflow to compute the profitability of the project. As shown by the formula above, the profitability index uses the present value of future cash inflows and initial investment to show the variables.