Management within the organization closely reviews the specific financial implications of an investment decision and applies several different evaluation methodologies to the supplied expectant financial data that is produced through a thorough researching of the different costs and benefits associated with the acquisition. The different methodologies applied will provide specific and accurate quantitative results that will relay relevant decision making information such as the amount of time it will take to recover the initial investment through subsequent inflows, the actual current or present value of the project adjusted to reflect the influence of the time value of money, and how well or capable this project will meet or exceed costs of capital, or the rate or return required (Gallagher, Andrew, 2003). With this information, management will be capable of making a confident investment decision, and will have specific measures by which they can adequately compare this investment project against any other options that might be present.
The tool that will be implemented to determine the length of time it will take for the company to recover its initial costs through the cash receipts or inflows that the project will generate is the payback method, or payback period. The payback period will often be referred to as the amount of time it will take for an investment project to pay for itself, and is generally expressed in years. The payback period will provide no details relative to profitability, it will only provide the analyst with an accurate length of time for investment recovery based on the net cash flows anticipated by investment performance (Garrison, Noreen, & Brewer, 2008). Calculation of the payback period is relatively simple, summing the project’s positive cash flows per period, typically annually, until the sum equals the project’s initial investment. The number of time periods passed before inflows are equivalent to original investment price represents the payback period. Internal requirements on the desired payback time will dictate what is deemed an acceptable result for a specific project. If the project can pay for itself within the time period allotted by investors, it is generally accepted. However, this method is not relied upon as a sole means for project evaluation and decision-making as it does not take into account the time value of money, nor does it account for the effects of cash flows that will incur after the point of payback (Gallagher, et al.).
The project evaluation method that is most aligned with the goal of increasing ownership value is the Net Present Value (NPV) method. The NPV of a specific investment project represents the exact dollar amount of change in the value of the company as a result of the acceptance of and investment in the project (Gallagher, et al.). The NPV method picks up where the payback period is inefficient, in that it provides a profitability gauge, and also takes into account the time value of money. The difference between the market value and the post of the project is the NPV, and realization that interest rates and inflation will impact this value over time is the principle behind the discounted cash flow valuation technique used in figuring the NPV. Using project data, such as periodic cash flows and the hurdle rate, a specific present value multiplier is applied to the value of the project, reflecting a more realistic value of the project as the actual value will change over time. Calculation of present value consists of discounting the annual net cash flows, and comparing that present value figure to the original investment amount. If the NPV produced is negative, that indicates the value of the firm will actually decrease in value and that the project should be rejected. If the NPV is positive, it indicates the firm’s value will increase by that particular amount, and should be accepted (Gallagher, et al. and Ross, Westerfield, & Jordan, 2008). Having the capability to view individual investment projects as the actual dollar amount of value they bring to the organization assists management immensely in being able to more wisely decide between different investment options.
The NPV technique of valuation falls short in that it is difficult to explain or understand by managers that do not possess a solid financial background. That complicates using the NPV analysis as a persuasive tool when presenting projects as viable options for the company. There is also the problem that the NPV presents the project’s value in the form of a dollar amount, making comparison with other alternatives more difficult. The IRR, or internal rate of return method, will serve to provide the user with a percentage of profitability that will make up for the lack of an easier method of comparison and persuasion, and provide management with a result indicative of whether or not a project will sufficiently meet the associated costs of capital. The IRR will also take into account the time value of money, but will express the project’s performance as a percentage. The IRR produced by the IRR calculation is compared to the required rate of return for the project, and the decision to accept or reject the project hinges on the ability of the project to meet or exceed the desired return rate. The IRR, however, does not take into account the financial impact of reinvestment of the project’s cash inflows on the project’s overall value (Gallagher, et al.).
The modified internal rate of return, or MIRR, will work similarly to the IRR, only the MIRR technique will include the effects of reinvestment of project inflows on project performance. Using the reinvestment rate, all cash flows, with the exception of initial outflow, is calculated using the IRR technique to provide a different figure that will also be compared with the hurdle rate, or management’s required rate of return for the project (Ross, et al.). The MIRR will provide a more conservative expectation of actual project performance, making comparison to other projects and the decision to accept a more confident one (Alexander, 2008). The reinvestment of inflows does not actually change the amount of inflows expected from a project, therefore the actual value is not changed by the MIRR. However, to actually receive the value as described by the IRR method, is to reinvest the project’s cash flows at the rate of return. The IRR investment assumption of reinvestment at the rate of return is automatically built in to the IRR calculation, therefore, if the actual reinvestment rate associated with the project’s inflows is at a different rate, a difference in return is reflected, and produced by the MIRR calculation (Ross, et al. and Gallagher, et al.). Similar to the IRR, whether or not the project is accepted or rejected based on the MIRR, is how the MIRR compares to management’s required rate of return.
Separately, the different investment evaluation techniques provide the user with specific and relevant results that will assist in choosing wisely only those projects that will bring added value to the organization and meet the requirements of the investors. These methods further provide quantitative results that are easily communicated and compared to the results of other investment options, further enhancing the decision-making process. Consequently, each method focuses on a specific performance dynamic and no one method should be used solely to evaluate and decide upon an investment choice. Given that each method compliments the other methods, and gives the user the relevant data or considerations that were not present in the other methodologies, all methods should be applied to proposed investment projects to gain a more complete view and understanding of the expected impact of each project on the organization.
Cited Sources:
Alexander, S. (2008). Live chat session #5. Colorado Technical University Online. MGM625-
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Gallagher, T.J. and Andrew, J.D., Jr. (2003). Financial management: principles and practice, 3e.
Prentice Hall. Upper Saddle River, NJ.
Garrison, R.H., Noreen, E.W., and Brewer, P.C. (2008). Managerial accounting, 12e. McGraw-
Hill Irwin. Boston, MA.
Ross, S.A., Westerfield, R.W. and Jordan, B.D. (2008). Fundamentals of corporate finance, 8e.
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