Question

You are one of the potential investors in a business . Explain how you would go about evaluating the proposed investment. Use at least three different methods of evaluating investments. Describe the three different methods, and explain which one of these methods used is the best for this particular decision. Motivate your answer. Describe any potential negative issues of the chosen method which you should be aware of.

Answer must be between 1500-2000 word counts

Answer 1

                                    Companies use several techniques to determine if it makes sense to invest funds in a capital expenditure project. The attractiveness of a capital investment should consider the time value of money, the future cash flows expected from the investment, the uncertainty related to those cash flows and the performance metric used to select a project.

                               After determining cash flows and the cost of capital, managers can begin to evaluate various capital investment alternatives. The most commonly employed technique for evaluating investment alternatives is the net present value technique. Variations of this technique include the profitability index and the internal rate of return.

Methods of evaluation of investment

1. Urgency Method:

In many situations in the life of a business concern an ad hoc decision is needed in respect of investment expenditure. For instance, if a part of machine stops working leading to complete break­down and disruption in the production process, it will be justified to replace it immediately by new one even without comparing the cost and future profit. Any decision on investment expenditure on the basis of urgency should be taken only if it is fully warranted and justified.

2. Pay-Back Period Method:

This is also known as ‘payoff and pay out’ method. This method is employed to determine the number of years in which the capital expenditure incurred is expected to pay for itself. This method describes in terms of period of time, the relationship between cash inflow and total amount of invest­ment. The pay-back period is the number of years during which the income is expected. The criterion here is that the average income from a proposed investment be sufficient to cover investment within a period of time. It is calculated by dividing investment by the amount of return per annum after charging taxation but before charging depreciation.

Advantages of pay back period

a. It is easy to understand and calculate.

b. It takes into account the time value of money.

c. This method helps in selection of a profitable project from among mutually exclusive projects very easily

Dis advantages of payback period

a. It does not take into account the cash inflows that occur after the payback period

b. Selection of appropriate rate for discounting the cash flows is another problem.

Equation for pay back period

Pay-back Period = Net Investment/Cash Inflow

3. Unadjusted Return on Investment Method:

This method is also called Accounting Rate of Return Method or Financial Statement Method or Return on Investment or Average Rate of Return Method. Here the main feature is that the rate of return is based on the figures for income and investment which are determined according to conventional accounting concepts. The rate of return is expressed as a percentage of the earnings to the investment in a particular project. There is no general agreement as to what constitutes investment and income. Income may be taken as the average annual earnings, normal earnings or the earnings of the first year of the project. Investments may be taken as the initial investment or the average outlay over the life of the investment.

The rate of return on investment refers to the rate of interest that will make the present value of future earnings just equal to the cost of investment.

Annual Average Net Earning/Original Investment x 100

The term average annual net earnings is the average of the earning over the whole of the economic life of the project.

Increase in Expected Future Annual Net Earnings/Initial Increase in required Investment x 100

4. Net Present Value Method:

The net present value method is one of the discounted cash flow or time adjusted method. This is generally considered to be the best method for evaluating capital investment proposals. In case of this method, cash inflows and cash outflows associated with each project are first worked out. The net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

The advantages of NPV are:

a. It recognizes the time value of money.

b. It takes into account the entire series of cash flows for analysis.

c. Selection of project under mutually exclusive projects is easy under NPV

Dis advntages of NPV

a. In comparison to traditional method, it is slight difficult to understand and calculate.

b. Selection of the discount rate for discounting of cash inflows is another problem of NPV.

5. Internal Rate of Return Method:

This method is also called Time Adjusted Return on Investment or Discounted Rate of Return. This method measures the rate of return which earnings are expected to yield on investments. Internal rate of return is defined as the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the projects.

The rate is similar to the effective rate of interest calculated on debentures purchased or sold. This is calculated on the basis of the funds utilized from time to time as opposed to the investment made at the beginning. This method incorporates the time value of money in the investment calculation.

The advantages of IRR are:

a. It recognizes the time value of money.

b. It considers cash inflows and cash outflows over the entire life of the project.

c. In case of mutually exclusive projects, it helps select a project very easily.

Disadvantages:

a. It involves lengthy and tedious calculations.

b. Sometimes a project may have multiple IRR which confuses users.

c. Projects selected on the basis of higher IRR may not be profitable in all cases.

6. Benefit-Cost Ratio Method:

This method is based on time adjusted techniques and is also called Profitability Index or Desir­ability Factor. The procedure of deriving the benefit cost ratio criterion is the same as that of NPV. What is done is to divide the present value of benefit by the present value of cost. The ratio between the two would give us the benefit-cost ratio which indicates benefit per rupee of cost.

                               One of the drawbacks of non-discounted techniques for evaluating investment criteria is the ignorance of timing of cash inflows and outflows. Another drawback of traditional techniques is that entire cash proceeds are not taken into consideration for analysis.