Capital investment decisions are based on accurate analysis of cash flows in a business. Managers can choose from several analytical techniques to analyze cash flows. Some techniques take into account the time value of money and some do not.
Respond to the following in a minimum of 175 words:
- Briefly describe 2 analytical techniques based on the time value of money concepts.
- Briefly describe 2 analytical techniques which are not based on the time value of money concepts.
- Describe what you consider to be the top 2 advantages and 2 disadvantages of each technique and provide an example to support your top advantage of each method.
Reply to these two classmate’s statements below whether you agree or disagree. State why and explain. or your faculty member. Be constructive and professional. You will respond in 100 words each statement.
- 1)
Hi Everyone,
One analytical technique based on the time value of money concept is Net Present Value (NPV), which is a commonly used capital investment analysis technique that calculates the present value of cash flowing both inward and outward from an investment project. It also uses a predetermined discount rate, discounting future cash flow into their present value which is the original cost to begin with. Two advantages of this are the fact that NPV is use with the insight that the value of the money at present differs than that of the equal amount, thus also providing an idea of the profitability of an investment with the measurements of the present value surplus in comparison to the base investment itself. An example being an organization deciding to secure an investment from Party A who offers $20,000 or Party B who offers $15,000, using this method the best option would be Party A. Two disadvantages of the NPV method: there can be difficulty in accurately determining cash flows and discount rates; and it also it difficult to compare the profitability of differing projects solely based on NPV as it does not provide a rate of return.
Internal Rate of Return is another analytical technique based on the time value of money concepts that calculates the discount rate that present value of cash outflows with advantages of providing a rate of return and it is not dependent on the required rate of return. This can best be shown through when evaluating projects with similar size and or durations; for example, if there is a Project A with an IRR of 20% and a Project b with an IRR of 16% according to the IRR method it would be suggested that Project A should be chose. Its disadvantages include: the fact that IRR holds no account of cash flows or dollar value and holds the assumption that cash flows at constant rate are reinvested, and they are surely not; secondly, IRR can lead to multiple rates of return.
Payback Period is not based on the time value of money concepts, it is an analytical technique that measures the time required to recover the initial investment in a project; calculated by dividing the initial investment by the average annual cash flow coming in. A disadvantage is being that the payback period does not consider cash flows coming in after this period is over, having no regards for total profitability. Another disadvantage is that an acceptable payback period is considered to be subjective and can vary between firms and even within the same firm. Two advantages are the risk assessments it helps to provide and its suitability for small business. An example being providing a small business owner two options for purchasing a new brick wood oven Option 1 costs more upfront however has a shorter payback period while Option 2 costs less upfront but has a longer payback period. This has just provided a quick snapshot of the potential risks present and offers simplicity for small business owners to utilize.
Accounting Rate of Return, or Average Rate of Return; evaluates investments projects based on accounting profits instead of cash flow measuring the average annual profit generated by the project as a percentage of the starting investment. It advantages are providing an overall snapshot of an organization’s financial performance as well as benefitting from long-term returns and can help minimize the possible impact of a single year of losses. It has disadvantages of ignoring cash flow and instead placing value on profits while also not taking into account the timing profits as well as not considering risks leading to overestimating the return on high-risk investments and underestimating the return on low-risk investments.
2)Analytical Techniques Based on Time Value of Money Concepts
Net Present Value (NPV) calculates the present value of future cash flows from an investment, discounted at a specified rate of return. This method helps determine if an investment will yield a positive return by comparing future cash inflows to the initial cost. NPV’s key advantage is its accuracy in assessing profitability by considering the time value of money, providing a comprehensive evaluation of all cash flows. However, NPV can be complex to calculate and relies heavily on accurate estimates of future cash flows and discount rates. For instance, a company might use NPV to decide on investing in a new plant by comparing expected future profits to the initial cost.
Internal Rate of Return (IRR) calculates the discount rate at which the present value of future cash flows equals the initial investment, representing the break-even cost of capital. IRR’s main advantage is its intuitive measure of potential return, aiding in project comparisons (Kimmel, Weygandt & Kieso, 2020). However, IRR can be misleading for projects of different durations or sizes and may produce multiple values for non-conventional cash flows. For example, a company choosing between two investments can use IRR to identify which offers a higher return relative to its cost of capital.
Analytical Techniques Not Based on Time Value of Money Concepts
Payback Period measures the time required to recover the initial investment cost. Its simplicity and ease of use make it advantageous for quick decisions, providing a straightforward measure of liquidity risk. However, it ignores the time value of money and cash flows after the initial investment is recovered, potentially missing long-term profitability(Kimmel, Weygandt & Kieso, 2020). A company might use the payback period to evaluate how quickly a new piece of machinery can recoup its cost.
Accounting Rate of Return (ARR) calculates the average annual accounting profit from an investment as a percentage of the initial cost. ARR is simple and uses readily available accounting data (Olayinka, 2022). However, it ignores the time value of money and focuses on accounting profits rather than cash flows, which may not reflect true economic benefits. A small business owner might use ARR to quickly compare potential investments based on accounting profits.