Financial executives face the task of ranking capital projects in order to determine which of these proposed investments will be the best economic choice
Guided Response: Review the posts from your classmates and respond to at least two. Compare and contrast the points you and your classmates made regarding the three methods of ranking capital investment proposals. Each response should have a minimum of 100 words.
Tonya Hatcher
Mar 3, 2021 at 9:31 PM
Financial executives face the task of ranking capital projects in order to determine which of these proposed investments will be the best economic choice while ensuring maximum long-term sustainability. In order to make these decisions, there are three primary methods to help in evaluating capital expenditures.
The first of these methods is the payback method. This method computes the time required in order to regain the initial investment amount (Block et al., 2019). This method, though widely used, has some major disadvantages. No consideration is given to the inflows of cash after the initial cutoff period. This method also does not take the time value of money into account (Block et al., 2019). This simplistic method is widely used by U.S. corporations due to its ease of understanding and its emphasis on liquidity. The rapid payback would be important to those companies whose industry requires the latest and greatest in technological developments.
The second method often used is net present value (NPV). This is most often the preferred selection method in investment decisions. “The net present value is the sum of the present values of all outflows and inflows related to a project” (Block et al., 2019, p. 385). If the NPV is greater than zero, the project is accepted because it is expected to increase the company value. However, if it is less than zero, it should be rejected because it reduces the company’s value.
The final method presented by our text is the internal rate of return (IRR). This method will measure the profitability of a project as a return percentage, instead of dollars. In order to understand IRR, one must understand how it relates to NPV. According to our text, “the IRR is the interest rate that makes NPV equal zero” (Block et al., 2019, p. 387). Many compare the IRR to the yield to maturity of a bond (YTM). Where YTM equates the present value of bond payments to a bond’s cost, IRR equates the present value of project returns to its cost. When it is determined if the returns are high enough to justify the initial investment and that it exceeds some pre-set minimum threshold, the project is determined to be worth it. Both of the latter two methods give theoretically correct evaluations; whereas, the payback method produces some useful insights, it is definitely not a sound method of evaluation.
Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/
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