Question

Hello, please 200 words at least, thank you:

Q: There are several accepted methods of determining the monetary advantage of one investment opportunity over another: The payback method; zero discount rate; net present value; internal rate of return; modified internal rate of return; etc. Discuss one or more non-monetary factors that may influence a manager's otherwise objective decision in choosing one criterion over another. Also, which method do you consider the best?

Answer 1

The non-monetary factor that influences a manager’s otherwise objective decision in choosing one investment criterion over another is whether the criteria being selected is easy to understand and easy to interpret or not and whether it is intuitively more appealing. This is an important non-monetary factor that many a managers take into consideration when determining the investment criteria that they should chose. For example for most of the managers IRR (or the internal rate of return) is the most preferred investment criteria when it comes to capital budgeting analysis. The reasons why most of the managers prefer IRR is because they can easily comprehend this concept and then interpret it make their decisions. Since IRR is mentioned as a rate and since financial analysts and managers are wonted to think in terms of rates of return rather than absolute monetary terms they prefer the IRR criteria over other criteria like NPV, Payback etc.

The method that I consider the best is the MIRR (modified internal rate of return). This is because MIRR overcomes the drawbacks of the otherwise the very sound criteria of IRR. The problem with IRR is that it assumes that the cash flows of a project are re-invested at the project’s own IRR. MIRR overcomes this drawback and is based on the assumption that the cash flows of a project are re-invested at the cost of capital. This is a more realistic assumption and a more practical approach. Hence MIRR is superior to IRR and this is the reason I consider MIRR to be the best method.

(260 words)