Question

What two of the six methods used to evaluate projects, and decide whether or not they should be accepted, do you prefer as chief financial officer? Explain why you decided on the two and not the other four. List the perceived deficiencies of the four that were not selected.

Answer 1

The six methods used to evaluate projects -

1. Internal rate of return.
2. Net present value.
3. Payback period.
4. Discounted payback period.
5. Profitability index.
6. Accounting rate of return method.

As chief financial officer, I will prefer internal rate of return (IRR) and Net present value (NPV) method because both take time value of money into consideration as well as useful life of the project get factored into calculation

1. Internal rate of return:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from an investment equal zero.

The formula for IRR is:

0 = P₀ + P₁/(1+IRR) + P₂/(1+IRR)^2+ P₃/(1+IRR)^3 + . . . +P_n/(1+IRR)^n

Where P₀, P₁, . . . P_n are the cash flows for the respective periods 0,1, 2, . . . n, and
IRR equals the investment’s internal rate of return. Project is acceptable if IRR is more than the required rate of return.

2. Net present value: Net present value (NPV) compares the value of a dollar today of a project to the value of that same dollar in the future.

Net present value (NPV) of project = [Expected cash inflow/ (1+ Discount rate) ^n] – Initial cost of project

Where,

Time period n = 0, 1, 2, 3…….so on

Initial cost of project is the cash outflow at year 0

Expected cash inflow are CF1, CF2, CF3,…….so on at time 1, 2,3,……so on respectably

Projects with positive cash flows are considered a viable project and negative NPV projects are not acceptable.

The perceived deficiencies of the four that were not selected -

1. Payback period does not take time value of money into consideration and also discourage the projects with higher all cash inflows at later years
2. Discounted payback period takes time value of money into consideration but it discourage the projects with higher all cash inflows at later years
3. Profitability index does not take useful life into consideration as it is calculated by dividing its present value of future cash flows by its initial cost
4. Accounting rate of return method does not take time value of money into consideration