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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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