Npv and Other Investment Citeria

Question: 1 - List the methods that a firm can use to evaluate a potential investment.

The Methods that a firm can use to evaluate their investment are;

1. NPV (Net Present Value) - The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of an investment

NPV = Present value of cash inflow- Present value of cash outflow

The investment should be accepted if the net present value is positive and rejected if it is negative.

2. Profitability index - Is a discounted cash flow technique in which present value of an investment’s future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio.

PI = PV of cash inflows / PV of cash outflows. If PI is positive, it will be accepted otherwise reject.

3. IRR (Internal Rate of Return) - The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. IRR can be used to rank several prospective projects a firm is considering.

4. Payback period - Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from inflows. It is a non-discounted cash-flow technique.

5. ARR (Accounting rate of return) - is a non-discounted cash flow method in which accounting information’s are used rather than cash flows.

ARR= (Average annual profit after tax/Average investment over the life of the project) * 100.

Question: 2 - Why is the NPV a preferred method when evaluating a potential investment opportunity?

NPV is a method of valuing an investment by discounting its future cash flows and by minus off the initial outlay. The investment should be accepted if the net present value is positive and should be rejected if it is negative.

Theoretical NPV is the better approach to capital budgeting due to several factors...