Investments are known as risky placement of money in financial institutions of some kind for the purpose of attaining a regular profit and a higher value of the investment when it is retrieved. Investment can be informs of buying stocks, assets, or some form of equity.
But do to some limitations of these tools other tools such as Profitability Index and Payback Period. The payback period determines the duration of the time it would take to recover the investment made initially. This will give us the number of periods it would take to breakeven for the initial investment made. The profitability index is used as well in investment decisions because it measures the value created per dollar invested. So if the PI shows a greater than 1 value, then it means that the investment is returning a greater amount than invested. These two techniques are used because they resolve the disadvantages of NPV and IRR methods. (Helmkamp, 1990)
The first disadvantage of a NPV calculation is its dependency on the interest/discount rates. It is very difficult for the investor to know the correct discount rate since they can change though out the life of that investment making considerable differences on the decision. (Investopedia, 2008)
Another issue with the discount rate is the differences in the risk factor of the investment. Since the risk can change, therefore the discount rate, this can make lives very hard in calculating NPV. (Investopedia, 2008)
Another disadvantage lies in the facts that NPVs are just mathematics calculations that do not take into account the real options available for investment. ...
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We then look at some questions which calculate the present value of the future cash flows and the future value of present cash investments. 1. The concept of time value of money is critical to the world of Finance and is very often the first subject that is taught in a Corporate Finance class.
It is therefore important that investments are done taking into consideration the opportunity cost of the other alternatives foregone. Time Value of Starbucks Bonds The amount I would pay for Starbuck’s bonds today depends on the expected rate of interest over the period in which the bond will be held.
Although, our decision is correct in financial terms, what we fail to understand is that the $ 10000 received today will not be equal to $ 10000 received five years from now because the $ 10000 today can be invested, providing us with interest and making the value of this $10000 higher ($10000 + interest).
Time value of money concept forms the basis of this annuity concept (Gordon, 1999). To understand the concept better, one must understand the concept of opportunity costs. Opportunity costs are the benefit that a person sacrifices by using money in a particular way.
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