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Evaluation of Investment Appraisal Techniques - Essay Example

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Evaluation of Investment Appraisal Techniques

(Ross et al., 2002). The latter case is in a situation where only one project is being evaluated. In the event were the company is evaluating a number of projects, for which only one will be selected, the decision criteria is to first of all discard all projects with negative net present values and then select the project with the highest net present value among the positive NPV projects. (Ross et al., 2002; Myers and Brealey, 2002).
It measures the change in the net worth of the firm due to the project (Cheng et al., 1994). NPV can also be derived from "discounting the expected future payoff by the rate of returns offered by comparable investment alternatives" (Richard and Bill, 2003). The vital stage of calculating NPV is to estimate the opportunity cost of capital (discounted rate) properly in order to discount future cash flow that forecasted of investment project (Brealey, Myers and Marcus, 2007). Under this method, every project with a positive NPV can be accepted to invest (Frank, 1999). NPV is a superior method of investment appraisal in theory, and recent study approved that it the most preferred tool in practices in management perspectives (Patricia and Glenn's, 2002). This could because of its major advantages in consideration of time value of cash flows. However, Michael (2004) indicated a weakness in application of NPV, managers face more difficult practical issues-such as the estimation and timing of cash flows. This adjustment could impact on likelihood of project acceptance. Additionally, NPV may fail as the method primary assumes there is no restriction on the amount of company's investment, yet in practice there is a certain constraint on company's investment budget, which depends on its size (Frank, 1999).
A simple mathematical illustration of the net present value technique would be done by using a situation of non constant cash flows generated by a project. For instance, Company LMN invest in the purchase of a manufacturing machine costing $65,000, which is to last for five years. The cash flows are not constant over the life of the project. The table below shows the distribution of cash flows as well as the calculation of the net present value of the investment.

Table 2.: Company LMN Net Present Value Calculation.
Years
0
1
2
3
4
5
Cash flows(CFs)
-$65,000.00
$15,000.00
$25,000.00
$20,000.00
$35,000.00
$40,000.00
*Discount factor@12%
1.000
1.120
1.254
1.405
1.574
1.762
**Present Value(PV)
-$65,000.00
$13,392.86
$19,929.85
$14,235.60
$22,243.13
$22,697.07
***Net Present Value
$27,498.52





Notes:
*The discount factor is calculated by dividing the discount rate by 100, adding 1 to the result, and raising the output to the power "years";
**The present value is calculated by dividing the cash flow of each year to its corresponding discount rate;
***The Net present value is calculated by summing the present values, that is,
NPV = -C0 + PV of Cash Flows in Year 1 + PV of Cash Flows in Year 2 + + PV of Cash Flows in Year 5.
Where C0 is the initial investment of $65,000.
b. The internal rate of return (IRR) method of investment appraisal
IRR measures the periodic rate of return for the project's required ...Show more

Summary

Net Present Value gives more explicit concerns to the time value of money and it is as well considered more crucial in investment appraisal than the traditional methods of payback and accounting rate of return. Net Present Value is calculated by subtracting the initial investment from the present value of net cash flows discounted at a rate equal to the company's cost of capital…
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