6.1 PROJECT VALUATION METHODS Flashcards
1 PROJECT VALUATION METHODS
1) Average Rate of Return (ARR)
2) Payback Period
3) Net Present Value (NPV)
4) Internal Rate of Return (IRR)
5) Profitability Index (PI)
ARR
Average Rate of Return
ARR= averahe anual return after taxes/ Capital investment
ARR strength and weakness
Strengths
The biggest strength of the Average Rate of Return technique is its simplicity; it makes use of
readily available accounting information.
Weaknesses
1) ARR fails to take account of the number of periods cash flows occur.
2) ARR ignores the time value of money: benefits in the last year are valued the same as
benefits in the first year.
Payback period
Payback= capital investment in the projects/annual cash flowsin the recovery period
Payback period strength and weakness
Strengths
The payback method remains one of the more popular techniques as it provides management
limited insight into the risk and liquidity of a project. The shorter the payback period the less
risky the project and the greater its liquidity. Companies that are cash poor find payback to be
very useful, as it gauges the earliest possible recovery time for funds invested.
Weaknesses
1) The payback method fails to consider the cash flows after the payback period has elapsed.
For example, if two proposals A and B required the same capital investment of $100,000,
both had a net cash flow of $50,000 pa. Proposal A paid the $50,000 cash flow until
payback (2 years) and Proposal B paid the $50,000 cash flow for 10 years. The payback
would fail to recognise that even though payback is identical Proposal B is clearly the
better investment.
2) It ignores the time value of money
NPV
Net Present Value
NPV=
-A0 + A1/(1+k)^1 +A2/(1+k)^2 + An/(1+k)^n …
If the sum of the discounted cash flows equals zero or more the project is accepted, otherwise
it is rejected. In other words, a project is accepted if the cash in flows exceed the present value
of cash outflows.
IRR
Internal Rate of Return
-A0 + A1/(1+k)^1 +A2/(1+k)^2 + An/(1+k)^n …= 0 k=?
the IRR represents the rate of return that makes the sum of the present values of cash inflows and outflows equal to zero.
The internal rate of return k is compared with a required rate of return, sometimes referred to
as a hurdle rate. If the internal rate of return is higher that the required rate of return the
project is accepted. Accepting a project with an internal rate of return in excess of the required
rate of return should result in an increase in the share price.
PI
Profitability index
NPV/ initial investment
or
NPV/0
As long as the profitability index is 1.00 or greater the investment proposal is acceptable. For
any given project the net present value and profitability index give the same accept-reject
signal.
mutually exclusive
nvestment opportunities that cannot be pursued simultaneously because their cash flows are related in a way that accepting one project precludes accepting the others
contingent proposal
depends on the acceptance of on or more other investment proposals.
differences in the decisions produced from NPV and IRR
- Compounding Rate Differences
- Scale of Investment
- Multiple Rates of Return
NPV is more reliable than IRR
NPV always provides the correct ranking of mutually exclusive projects, where as IRR
sometimes does not. This is because in the case of IRR implied re-investment rate differs
for each proposal. For proposals with a high IRR, a high re-investment rate is assumed
and for proposals with a low IRR, a low re-investment rate is assumed. In the case of
NPV, however, the implied re-investment rate, the required rate of return, is the same for
each proposal.
* NPV takes account of scale of investment, where IRR does not.
* IRR also has the problem of multiple IRR’s - a disadvantage relative to NPV
However, despite its weaknesses IRR is a very intuitive measure to which most investors can
relate. As a result, IRR continues to be popular and is generally used in conjunction with
NPV
