Because of the various disadvantages of the average rate of return methods and recovery period, it is generally believed that discounted cash flow methods provide a more objective basis for evaluating and selecting investment projects. These methods take into account both the magnitude and the periodicity of the expected cash flows in each period of the duration of a project.
The two methods of discounted cash flow are the internal rate of return and the present value that. Recall that the internal rate of return for an investment proposal is the discount rate that equals the present value of the expected cash outflows with the present value of the expected income. It is represented by the rate r, so that where a t is the cash flow for period t, either income or net cash income and n is the last period in which a cash flow is expected. If the initial outlay of cash or cost occurs at time 0, the above equation can be expressed as, so r is the rate that discounts the series of future cash flows -A 1 to an n – to match the initial outlay at time 0, a 0. For our example, you can express the problem as when searching for r through a computer, a programmed calculator or the manual method we find that the internal rate of return for the project is 17.57%.
The acceptance criterion that is generally used with the internal rate of return method is the comparison of the internal rate of return with a required rate of return, also known as the cutoff rate or obstacle. If the internal rate of return exceeds the required rate, the project is accepted; if not, it is discarded. If the required rate of return is 12% AND this criterion is used, the investment proposal that is being considered will be accepted.
The acceptance of a project with an internal rate of return that exceeds the required rate of return should result in an increase in the price of the shares in the market, because the company accepts project that has a performance higher than necessary to maintain the current price of the stock in the market. Of capacity can be differentiated from cost reduction projects and, therefore, demand a different performance. Edward M. Miller reasons that capital expansion projects are highly related to the level of economic activity, 10 which produces considerable cash flows when the economy is prosperous. 2 If we rely on the concepts presented in chapter 3, we would conclude that it would be high the systematic risk of the project. In contrast, replacement projects are cost-reducing and would be likely to produce benefits.
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