The payback method also has some desirable features for managerial control Just

# The payback method also has some desirable features

This preview shows page 20 - 22 out of 60 pages.

The payback method also has some desirable features for managerial control. Just as important as the investment decision itself is the company’s ability to evaluate the manager’s decision- making ability. Under the NPV’s method, a long time may pass before one decides whether or not the decision was correct. With the payback method we know in three years whether the manager’s assessment of the cash flows was correct. 3.2.3. The Internal Rate of Return The Internal Rate of Return universally known as the IRR is being called the most important alternative to the NPV method. The IRR is very close to NVP, but actually is something different. The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project. That number does not depend on the interest rate, that’s why it is called the internal rate of return; the number is internal to the project and does not depend on anything except the cash flows of the project. In general, the IRR is the rate that causes the NPV of the project to be zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. The general investment rule then is: accept the project if IRR is greater than the discount rate, reject the project if IRR is less than the discount rate. You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.
21 3.2.4. The Profitability Index Another method that is used to evaluate projects is called the profitability index. It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. The profitability index can be represented as A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. 3.2.5. Return on Investment ROI (Return on Investment) is a „performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.“ 6 . It is a very popular metric thanks to its versality and simplicity. If an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should not be made.

#### You've reached the end of your free preview.

Want to read all 60 pages?