Select one of the capital investment evaluation methods described in Chapter 10 of your text. Fully explain the capital evaluation method’s strengths and weaknesses. Take a position and defend the use of your selected method. Be sure to use at least two scholarly sources to support your position.
A common purpose of investing in business is to have different avenues to generate more profits from existing profits in the hope to ensure present and future financial security. Management teams are responsible for making capital investment decisions, which are based on how the firm will handle the businesses’ cash outflows and inflows. There are four capital evaluation methods, net present value method, internal rate return (IRR) method, payback period method, and accounting rate of return method. Each method has it various strengths and weakness. I choose to discuss the net present value method of capital evaluation. According to Schneider (2017), “the net present value method includes the time value of money by using an interest rate that represents the desired rate of return or, at least, sets a minimum acceptable rate of return” (p. 417). The net present value method can assist managers to evaluate the effectiveness of investments. According to Tomaševič, (2010), the method calculation is based on the assessment of three main variables, 1) net cash flow; 2) length of the period considered and the interval of analysis; and 3) discount rate” (p. 363). The fundamental rule of the net present value method is profit maximization and is commonly used as an economic calculation to compare and rank competing projects (Fuller, 2013). Like every method its use comes with its advantages and disadvantages.
The most notable strength of this method is its ability to account for the future value of a dollar. However, a weakness of the technique is that it can be estimation, as it does not provide exact data on the project’s precise rate of return as it only specifies whether the investment is earning more than or less than the minimum acceptable rate of return (Schneider, 2017). While the use of the net present value method does require some presumption it is still an effective method to analyze investments profitability because of the fact it takes into consideration that the present value of the dollar is not the same as the future value of that same dollar. Ultimately, the basis of investing is to maximize wealth and the net present value method can be a highly successfully tool to determining which project is in the best interest of the company to achieve profit maximization.
Fuller, E.W. (2013). The Marginal Efficiency of Capital. Quarterly Journal of Austrian Economics, 16(4), 379-400. https://doi-org.proxy-library.ashford.edu/http://mises.org/periodical.aspxId=4 (Links to an external site.)
Schneider, A. (2017). Managerial Accounting: Decision making for the service and manufacturing sectors (2nd ed.) [Electronic version]. Retrieved from https://content.ashford.edu/ (Links to an external site.)
Tomaševič, V. (2010). Evaluation of investment projects’ effectiveness by the net present value method. Business: Theory and Practice, 11(4), 362-369. https://doi.org/10.3846/btp.2010.39 (Links to an external site.)
The three capital investment methods are 1)Present Value (PV) 2) Payback period and 3) Accounting rate of return. The method that I will be discussing is the PV method and specifically the NPV (net present value). When using the NPV method it is taking the time-value of money and is calculating an acceptable rate of return (Schneider, 2017). In summary the NPV is the difference between the PV and the incremental net cash inflows and outflows.
A advantage that the NPV has is that it uses the present-value of money rather than today’s value. We all know that money decreases in its value over time therefore this calculation give an accurate description of how the cash flow will look in the future. According to Espinoza (2013), “Because of its simplicity, the most widely used project valuation technique for capital budgeting and investing is the net present value (NPV) method, along with its close retaliative, the internal rate of return (IRR)” (p.471).Many say the NPV is the gold standard when looking at long-term decisions (Magni, 2016). One disadvantage is the accuracy of guessing future net cash flows and this could be difficult when assets and projects has various life spans. With that being said I don’t think that the disadvantage is a cause for concern. Every aspect of budgeting is essentially a guess and the same goes with estimating capital.
Espinoza, D., & Morris, J. F. (2013). Decoupled NPV: a simple, improved method to value infrastructure investments. Construction Management & Economics, 31(5), 471–496. https://doi-org.proxy-library.ashford.edu/10.1080/01446193.2013.800946 (Links to an external site.)
Magni, C. A. (2016). An Average-Based Accounting Approach to Capital Asset Investments: The Case of Project Finance. European Accounting Review, 25(2), 275–286. https://doi-org.proxy-library.ashford.edu/10.1080/09638180.2015.1009143
Schneider, A. (2017). Managerial Accounting: Decision making for the service and manufacturing sectors (2nd ed.) [Electronic version]. Retrieved from https://content.ashford.edu/