Investment Decision Methods
Investment Decision Methods
Financial managers use many different kinds of investment decision methods while making capital investments. The four widely used and major methods are
ii. Net present value (NPV)
iii. Internal rate of Return (IRR)
iv. Modified Internal Rate of Return (MIRR)
The payback method tells us the time that is needed to retrieve a projects cost. When we have to select between two projects we will choose the one which has a shorter payback period or which is returning the costs in a shorter time period. Advantages of the payback method are that it is easy to calculate and that it gives a good indication of projects liquidity. But the disadvantages are that it does not consider the time value of money and does not consider those cash flows which occur after the payback period.
The Net Present Value method tells us the sum of the present value of the projects cash inflows and cash outflows. When deciding for NPV the first consideration should be whether the two projects are independent or mutually exclusive. For the independent projects accept all projects which have a NPV greater than zero. While for mutually exclusive projects; the project with the highest NPV should be selected. Some advantages of the NPV method are that it gives information if the invest will increase the firm’s value. Moreover it considers three important aspects; the time value of money, all cash flows involved and the risk associated with the future cash flows. While its disadvantages are that it has to approximate the cost of capital for the calculation of NPV and it gives the result in absolute terms rather than percentages.
Internal Rate of Return method tells us the discount rate at which the present value of future cash inflows is equal to the cost, the NPV at such a point is zero. In case of IRR method; if the IRR is greater than the Weighted Average Cost of Capital (WACC) the project should be accepted while if it is less than WACC it should be rejected. The IRR method and NPV method have many common advantages and disadvantages as discussed while discussing NPV. In case of the IRR method the basic advantage is that it gives the rate of return on the original investment. While the disadvantage is that it can give you conflicting values for the IRR when calculating for mutually exclusive projects.
Modified Internal Rate of Return method tells us the discount rate at which the present value of the projects terminal value is equal to the present value of the cost. In this scenario the terminal value is calculated by compounding the future inflows at WACC or any suitable rate chosen by the analyst. When making the accept reject decision the project should be accepted when the MIRR is greater than the NPV and rejected if the case is opposite. The advantages of the MIRR method are almost similar to the IRR method but one added advantage is that it gives only one rate even in case of mutually exclusive projects. The disadvantage is that it assumes a rate while finding the terminal value this assumption can make the whole project doubtful.
Deciding which method is the most accurate and reliable is a tricky job sometimes. The payback method and the MIRR method are not considered to be reliable because of their major disadvantages mentioned above. While the NPV and IRR methods are both considered reliable and are the basic tools to judge any investment decision. Both give similar results when deciding independent projects. While deciding mutually exclusive projects the NPV method is considered more reliable and accurate because the IRR method sometimes provides two IRR values, it is rather difficult to calculate and it makes a reinvestment supposition which is very unrealistic. Due to the factors mentioned above NPV is considered the most reliable and accurate investment decision method.
University/College: University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
Date: 10 October 2016
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