Submitted by: Submitted by denniseaston
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Category: Business and Industry
Date Submitted: 06/12/2011 09:07 PM
The book refers to a series of cash flows lasting several periods as a stream of cash flows. As with single cash flows, we can represent a stream of cash flows on a timeline. In this chapter we will continue to use timelines and the rules of cash flow valuation introduced in Chapter 3 to organize and then solve financial problems.
The Net Present Value (NPV) method of capital budgeting is by far the most utilized and most accurate method. NPV calculates the present value of cash flows over a period and subtracts the current required outlay (original investment) from the inflows over the period. If the inflows, when adjusted for the interest factor, exceed the original investment; the investment is expected to produce more wealth for the shareholders.
The internal rate of return (IRR)method allows a company to see what rate of return would make the investment a wash--the invested amount would generate that amount of return (when adjusted for the discount rate). If the calculated break-even interest rate is greater than the expected interest factor, then the project would represent a positive return on investment. I think an example most of us could understand is if I buy a repo home with the intention of renting the house out. I have to invest $50,000 to purchase the home and will be paying 5% interest over the next 20 years. Using the IRR method, I would find out at what rate of return I could expect based on the rental income I would generate. If the rate of return that has me break even with the investment is greater than 5% then, on that basis alone, the investment would be acceptable.
The profitability index (PI) is useful when trying to compare 2 possible projects. Since a project is considered to be ultimately positive if the PI is greater than 1.0 (meaning that the project will return greater than $1 for each $1 invested), a company that can only invest in one project could use the comparitive values to determine which project would return...