Management: Net Present Value and Cash Flows Essay

Submitted By ramchinna24
Words: 357
Pages: 2

According to Hamilton, F., Black, C. & Tozer, L. (2005), after the estimation of the benefits and costs of a project, the proposal must be evaluated to assess its financial feasibility in relation to company’s pre-determined selection criteria. There are four techniques of investment appraisal in capital budgeting: accounting return on investment (AROI), payback period, net present value (NPV), internal rate of return (IRR). AROI measures the profitability of an investment percentage of the dollars invested. It is generally used to estimate the annual performance of a business unit. Average profit after tax AROI = ------------------------------x 100 Initial investment |

This method is very simple to calculate and familiar to most managers. But it fails to consider the time value of money as it uses only accrual data, not cash flows.
IRR is the percentage return expected to be earned from a project, taking in to account the time value of money. It is the discount rate that makes the NPV= 0. A firm should accept the project if IRR > cost of capital, as it add value to the firm. In the case of IRR = 0, the project should be accepted because it satisfies investors’ required rate of return although no extra value will be added to the firm. On other hand IRR gives multiple solutions and that is why it is not suitable for…