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ACC/543

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Finance

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Jan 9, 2024

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docx

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Capital investment decisions are based on accurate analysis of cash flows in a business. Managers can choose from several analytical techniques to analyze cash flows. Some techniques take into account the time value of money and some do not. Respond to the following in a minimum of 175 words: Briefly describe 2 analytical techniques based on the time value of money concepts. Briefly describe 2 analytical techniques which are not based on the time value of money concepts. Describe what you consider to be the top 2 advantages and 2 disadvantages of each technique and provide an example to support your top advantage of each method. Capital investment decisions are crucial for businesses, and managers they must analyze cash flows accurately to make informed decisions. There are several analytical techniques available to managers to analyze cash flows, some of which take into account the time value of money, while others don't. Two analytical techniques based on the time value of money concepts are: Net Present Value (NPV): This method involves converting future cash flow dollars into current values to determine if the initial investment is less than the future returns. NPV is a widely used technique that considers the time value of money and provides a clear picture of the profitability of an investment. It is a reliable method for evaluating long- term investments, as it takes into account the time value of money and the risk associated with the investment. For example, a company is considering investing in a new project that will generate cash flows of $10,000 per year for the next five years. The initial investment required is $40,000. Using the NPV method, the present value of the future cash flows is calculated, and if the NPV is positive, the investment is considered profitable. Internal Rate of Return (IRR): This method calculates the rate at which the present value of future cash flows equals the initial investment. IRR is another widely used technique that considers the time value of money and provides a clear picture of the profitability of an investment. It is a reliable method for evaluating long-term investments, as it takes into account the time value of money and the risk associated with the investment. For example, suppose a company is considering investing in a new project that will generate cash flows of $10,000 per year for the next five years. The initial investment required is $60,000. Using the IRR method, the rate of return that makes the present value of the future cash flows equal to the initial investment is calculated, and if the IRR is greater than the required rate of return, the investment is considered profitable. Two analytical techniques that are not based on the time value of money concepts are:
Payback Period: This method calculates the time required for the initial investment to be recovered from the cash flows generated by the investment. Payback period is a simple and easy-to-understand method that provides a quick estimate of the time required to recover the initial investment. It is useful for short-term investments that have a low risk. However, it does not consider the time value of money, and it does not provide a clear picture of the profitability of an investment. For example, suppose a company is considering investing in a new project that will generate cash flows of $10,000 per year for the next five years. The initial investment required is $60,000. Using the payback period method, the time required to recover the initial investment is calculated, and if the payback period is less than the required time, the investment is considered profitable. Accounting Rate of Return (ARR): This method calculates the average annual profit generated by the investment as a percentage of the initial investment. ARR is a simple and easy-to-understand method that provides a quick estimate of the profitability of an investment. It is useful for short-term investments that have a low risk. However, it does not consider the time value of money, and it does not provide a clear picture of the profitability of an investment. For example, suppose a company is considering investing in a new project that will generate cash flows of $10,000 per year for the next five years. The initial investment required is $60,000. Using the ARR method, the average annual profit generated by the investment as a percentage of the initial investment is calculated, and if the ARR is greater than the required rate of return, the investment is considered profitable.
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