For high capital investments that require longer periods of time to generate higher cash flow may not favor this method of evaluation. This method suits short-term investments. This method compares the cost of an investment with the profit generated by the investment (Hansen & Mowen, 2007). This method simply is a ratio of Annual return or profit to initial cost of investment. Its simplicity offers several limitations as it requires a benchmark rate for comparison. An investor needs to know what percentage return is worth investing in. There is no measure or initial method to determine what is the right investment return.
It ignores the time value of money just like Payback method. These two methods are called discount methods. NPV calculates the net value of the investment while taking into consideration the changing value of cash. This method tries to calculate the amount need to be invested to attain certain annual revenue in a specified period of time. The value of money will be affected by interest rates payable on a certain investment. This method is good in comparing alternative investments. NPV assumes a constant capital gearing.
This rarely happens as constant refinancing the project will be needed according to (Delaney, et al. This method cannot be used in environments where companies are facing capital rationing. Capital rationing is where there is a limitation to the amount that can be invested. In this situation, it is important to use both profitability indexing and NPV to evaluate the viability of an investment. NPV uses a process called discounting Cash flow. Using discounted cash flow method finance accountants can determine which investment over a longer period of time is more beneficial even though the first may yield higher returns in a shorter period of time.
This method is appropriate in evaluating different investments with the same cost. This method allows the risks associated with an investment are assessed. IRR discounts future cash flow of a given investment to the point where the Net Value Present is equal to zero.
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