A Critical Evaluation of Three Basic Methods of Evaluating an Investment (Irr, Payback and Npv).

2347 Words Dec 25th, 2012 10 Pages
Prepare a critical evaluation of three basic methods of evaluating an investment (IRR, Payback and NPV).

There are several basic methods of evaluating an investments that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for
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* It may give different rates of return; in essence it entails more problems than a practitioner may think. * It could be quite misleading if there is no large initial cash outflow.

The payback period
The payback period is defined as the time required to recover the initial investment in a project from operations. The payback period method of financial appraisal is used to evaluate capital projects and to calculate the return per year from the start of the project until the accumulated returns are equal to the cost of the investment at which time the investment is said to have been paid back and the time taken to achieve this payback is referred to as the payback period.
The payback method is computed as follows:
Payback Period= Initial InvestmentCash Inflow per Period
The payback decision rule states that acceptable projects must have less than some maximum payback period designated by management. Payback is said to emphasize the management’s concern with liquidity and the need to minimize risk through a rapid recovery of the initial investment. It is often used for small expenditures that have obvious benefits that the use of more sophisticated capital budgeting methods is not required or justified.
It should be noted that the required payback period sets the threshold barrier (hurdle rate) for
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