4 Responses Sep 18
Chandini Work:
Payback Period (PBP)
The payback period is an investment appraisal technique which tells the amount of time is taken by the investment to recover the initial investment or principal. The calculation of the payback period is very simple and its interpretation too. The advantage is its simplicity whereas there are two major disadvantages of this method. It does not consider cash flows after the payback period it also ignores the time value of money. Payback Period (PBP) is one of the simplest capital budgeting techniques. It calculates the number of years a project takes in recovering the initial investment based on the future expected cash inflows.
Payback Period = W + (X – Y) / Z
where W is the year before which the investment value is crossed in cumulative cash flows.
X is the initial investment or the initial cash outlay, Y is the cumulative cash flow just before the investment value is crossed in cumulative cash flows, Z is the cash flow of the year in which the investment value is crossed in the cumulative cash flows
Net Present Value (NPV)
Net present value or NPV is a very prominent technique for analysis in the arena of finance. Net present value is equal to the present value of all the future cash flows of a project less the initial outlay of the project. It is very important and useful in arriving at the decisions related to investment in projects, plants or machinery. Net present value is the present value/today’s value of an asset. In other words, it is the value that can be derived using an asset. Alternatively, it is a discounted value based on some discount rate. It is also widely used by banks, financial institutions, investment bankers, venture capitalists, etc to assess an asset or even a business for arriving at its valuation.
Future Cash Flows: Future cash flows are the expected cash flow to be received by the investor on the proposed investment.
Discount Rate: It is the highest rate of return which the investor can earn by investing the same money in some other investment alternative. In other words, a discount rate is the opportunity cost of capital which means the cost of compromising the other opportunity.
Initial Investment: It is the cash outflow at the beginning of the project like the cost of machinery etc.
Internal Rate of Return (IRR)
IRR is a prominent technique for evaluation of big projects and investment proposals widely used by the management of the company, banks, financial institution etc for their various purposes. The calculation of an IRR is a little tricky. It is advantageous in terms of its simplicity and it has certain disadvantages in the form of limitations under certain special conditions. The internal rate of return is a discounting cash flow technique which gives a rate of return that is earned by a project. We can define the internal rate of return as the discounting rate which makes a total of initial cash outlay and discounted cash inflows equal to zero. In other words, it is that discounting rate at which the net present value is equal to zero.
Initial Cash Outlay + Present Value of all Future Cash Inflows = 0
The major advantage of the IRR method of evaluating the project is that it simply tells what the project under concern will return in terms of percentage. Now the evaluator only needs to decide with which rate to compare it with. We do not need to decide on a hurdle rate in advance. A mistake in deciding the hurdle rate will not affect the result of this method.
The major disadvantage of the internal rate of return is its problem in analyzing a non-conventional project where cash flow stream has various positive and negative cash flows in various years. In this situation, it will give Multiple Internal Rate of Return (IRR). Another problem is that it does not consider the dollar value. The business of a roadside vendor who hardly earns his leaving will have higher IRR than very big and stable business. The vendor must be earning say 1000 dollar a year whereas the profit of that big business may be in millions.
Profitability Index (PI) or Benefit-Cost Ratio
Profitability Index (PI) is a capital budgeting technique to evaluate investment projects for their viability or profitability. Discounted cash flow technique is used in arriving at the profitability index. It is also known as a benefit-cost ratio. Calculation of profitability index is possible with a simple formula with inputs as – discount rate, cash inflows, and outflows. PI greater than or equal to 1 is interpreted as a good and acceptable criterion. Profitability Index is a ratio of discounted cash inflow to the discounted cash outflow. Discounted cash inflow is our benefit in the project and the initial investment is our cost, which is why we also call it to benefit to cost ratio.
The advantage of profitability method is that it considers the time value of money and presents relative profitability of the project. Relative profitability allows comparison of two investments irrespective of their amount of investment. A higher PI would indicate a better IRR and a lower PI would have lower IRR.
The main disadvantage of the PI method is also its relative indications. Two projects having the vast difference in investment and dollar return can have the same PI. In such a situation, therefore, the NPV method remains the best method.
Reference:
Besley, S., & Brigham, E. F. (2016).Essentials of managerial finance.Thomson South-Western.
Gitman, L. J., Juchau, R., & Flanagan, J. (2015).Principles of managerial finance.Pearson Higher Education AU.
Sravani Work:
Payback, net present value, internal rate of return, breakeven are different methods to calculate Return on Investment. For any business to succeed as time passes return on investment is very important which will define the financial growth.
Payback is the amount of time it takes to recover the cost of an investment i.e. payback period is the length of time an investment needs to reach the break even point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades (Kagan, 2020).
Net present value (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit. Consistent cash flows are building blocks in calculating net present value. NPV is used to calculate current value of future payments. If NPV is positive for a project, then discounted present value for future cash flows will be positive (Jagerson, 2020).
Internal rate of return (IRR) is the rate at which the project breaks even. It’s commonly used by financial analysts in conjunction with net present value, or NPV. That’s because the two methods are similar but use different variables. With NPV you assume a discount rate for your company, then calculate the present value of the investment. But with IRR you calculate the actual return provided by the project’s cash flows, then compare that rate of return with your company’s hurdle rate (how much it mandates that investments return). If the IRR is higher, it’s a worthwhile investment (Gallo, 2016).
The profitability index is a ratio of an investment’s benefits to the cost involved in making the investment. It is an index used to measure the present value of future cash flow compared to the initial investment. This measurement is more of a prediction of the profitability of investing in a given project. It helps you or the company using it to decide whether to invest in a project or not. This index can be used by individual investors to make investment decisions. However, it is mostly used by companies which are about to venture into projects, and they need to know their viability. It is also used to compare two or more different projects to decide which one to invest in. The use of the profitability index is in line with the need to maximize investments while lowering costs (Belyh, 2019).
References
Belyh, A. (2019, September 25). Understanding Profitability Index Method. Retrieved September 17, 2020, from https://www.cleverism.com/understanding-profitability-index-method/
Gallo, A. (2016, March 29). A Refresher on Internal Rate of Return. Retrieved September 17, 2020, from https://hbr.org/2016/03/a-refresher-on-internal-rate-of-return
Hayes, A. (2020, September 15). Internal Rate of Return (IRR). Retrieved September 17, 2020, from https://www.investopedia.com/terms/i/irr.asp
Jagerson, J. (2020, August 28). What Is the Formula for Calculating Net Present Value (NPV)? Retrieved September 17, 2020, from https://www.investopedia.com/ask/answers/032615/what-formula-calculating-net-present-value-npv.asp
Kagan, J. (2020, August 29). Payback Period Definition. Retrieved September 17, 2020, from https://www.investopedia.com/terms/p/paybackperiod.asp