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Utilizing the Time Value of Money - Essay Example
Pages 2 (502 words)
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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