![]() And if IRR is less than the required rate of return, then reject the project. ![]() If IRR is greater than the required rate of return for the project, then accept the project. In other words, IRR is the discount rate that makes present values of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflows. Internal Rate of Return refers to the discount rate that makes the present value of expected after-tax cash inflows equal to the initial cost of the project. Where CF0 = Initial Investment Outlay (Negative Cash flow) Further, if there is more than one project with positive NPV, then the project with the highest NPV shall be selected. If a project’s NPV is less than zero or negative, the same must be rejected. As per this technique, the projects whose NPV is positive or above zero shall be selected. In other words, NPV is the difference between the present value of cash inflows of a project and the initial cost of the project. NPV is the sum of the present values of all the expected incremental cash flows of a project discounted at a required rate of return less than the present value of the cost of the investment. This means that DCF methods take into account both profitability and time value of money. However, the DCF method accounts for the concept that a rupee earned today is worth more than a rupee earned tomorrow. Rather, these methods take into consideration present and future flow of incomes. And, it can reject the projects having ARR less than the expected rate of return.Īs mentioned above, traditional methods do not take into the account time value of money. Where, Average Income After Taxes = Total Income After Taxes/Total Number of Yearsīased on this method, a company can select those projects that have ARR higher than the minimum rate established by the company. Thus, ARR = Average Net Income After Taxes/Average Investment x 100 Under ARR method, the profitability of an investment proposal can be determined by dividing average income after taxes by average investment, which is average book value after depreciation. Cumulative net cash flow is the running total of cash flows at the end of each time period. Here, full years until recovery is nothing but the payback that occurs when cumulative net cash flow equals to zero. Payback period = Full years until recovery + (unrecovered cost at the beginning of the last year)/ Thus, if an entity has liquidity issues, in such a case, shorter a project’s payback period, better it is for the firm. Therefore, it is a measure of liquidity for a firm. Payback period refers to the number of years it takes to recover the initial cost of an investment. Furthermore, these methods do not take into account the concept of time value of money. Traditional methods determine the desirability of an investment project based on its useful life and expected returns. These techniques are categorized into two heads : traditional methods and discounted cash flow methods.
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