Fundamentally the mathematical basis of irr is not

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Unformatted text preview: ng projects with a “positive NPV,” subject to availability of capital. Fundamentally, the mathematical basis of IRR is not much different than NPV. The manual calculation of IRR using present value tables is a true pain. One would repeatedly try rates until they zeroed in on the rate that caused the present value of cash inflows to equal the present value of cash outflows. If the available tables are not sufficiently detailed, some interpolation would be needed. However, spreadsheet routines are much easier. Let’s reconsider the illustration for Greenspan. Below is a spreadsheet, using an interest rate of 8.8361%. Notice that this rate caused the net present value to be zero, and is the IRR. This rate was selected by a higher-lower guessing process (trying each interest rate guess in cell C7). This does not take nearly as many guesses as you might think; with a little logic, you can quickly zero in on the exact correct rate. 5.6 Payback Method The payback method could be called “investment decision making for dummies.” It is a popular and easy method, and can be valuable when the key investment goal is to find projects where the initial investment is quickly recovered. But, it is not very strong in otherwise pinpointing the best capital investment decisions. Payback is calculated by dividing the initial investment by the annual cash inflow. The earlier illustration for Greenspan has a payback of approximately 3.9 years ($500,000/$128,000 = 3.9). If an investment involves uneven cash flows, the computation requires scheduling cash inflows and outflows. The payback period is the point at which the cumulative net cash inflows begin to exceed the cumulative net cash outflows. Download free ebooks at 33 Evaluation of Long-Term Projects Analytics for Managerial Decision Making The method is deficient in that it does not take into account the time value of money. It also fails to reveal what happens after the payback period. For example, some investments may payback rapidly, but have little residual cash flow after the payback period. Other investments may take years to payback, and then continue to generate future returns for many more years to come. Although the investment with the shorter payback may be viewed as favorable, it could easily turn out to be the worst choice. All in all, be very cautious using the payback method for making business decisions. 5.7 Conclusion Please click the advert Capital budgeting decisions are not much different than the whole of managerial accounting. There are many tools at your disposal. You should understand these tools and how to use them. But, in the final analysis, good decision making will be driven by your own reasoned judgment. With us you can shape the future. Every single day. For more information go to: Your energy shapes the future. Download free ebooks at 34 Appendix Analytics for Managerial Decision Making Future Value of $1 Table Appendix 35 1 of 1 8/10/2009 1:...
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