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Capital Investments

CapitalInvestments

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SUBJECT:Methods of evaluating capital investment opportunities

Capitalinvestment refers to financial resources invested in business withthe aim of improving achievement (Abor,2017).Methods of calculating capital investment include payback period,internal rate of return, accounting rate of return method (ARR), andNet present value.

Paybackperiod

Accordingto Abor(2017), paybackperiod is the amount of time necessary for an investment to recoupthe amount spent when starting the business. Through payback periodmethod, an analyst discovers the most suitable way of finding outwhich is the most beneficial project to invest in.

Inagreement with Abor(2017), paybackperiod =Initial Investment /Cash Inflow for each Period

Advantages

Itis easy to calculate payback period when compared to other capitalinvestment calculating methods. Payback period is an easy way toprovide a good ranking of the plans of firms facing liquiditydifficulties (Abor,2017).

Disadvantages

Paybackperiod does not account for cash flows that happen after paybackperiod. According to Abor(2017), thepayback period method also does not put into much consideration theaspect of time value of money. Lack of consideration for time valueof money is detrimental as it can lead to bad decisions by themanagement.

AccountingRate of Return Method (ARR)

Accountingrate of return method uses the expected net operating income to beproduced by the venture project instead of concentrating on cashflows to so as to assess the venture proposition (Abor,2017).

Accountingrate return= Investment income ÷Cost of investment

Advantages

Accountingrate of returnis easy to calculate. Accountingrate of return method is advantageous in that it focuseson profits.

Disadvantages

Amajor demerit for accountingrate of returnmethod is that it does not put into consideration the critical aspectof time value of money (Abor,2017).

NetPresent Value

Netpresent value method is used to establish the present value of anenterprise by the discounted amount of all cash flows of the project(Abor,2017).

(Abor,2017)

Where

Ct= net cash inflow during the period t

Co= total initial investment costs

r= discount rate, and

t= number of time periods

Advantages

Netpresent value method directly measures the contribution of thecurrency to stakeholders. The net present value method also shows theprofit from the initial investment (Abor,2017).

Disadvantages

Innet present value method, the planned endeavor is not measured. Netpresent value method is also a very risky method because it canprovide disagreeing solutions.

InternalRate of Return (IRR)

Internalrate of return is used to calculate the potential profits of aninvestment in a particular venture.

(Abor,2017)

Where

Ct= net cash inflow during the period t

Co= total initial investment costs

r= discount rate, and

t= number of time periods

Whenusing this formula to calculate IRR, trial-and-error is applied untila satisfactory answer is found. During the calculations, NPV shouldbe set at zero.

Advantages

Internalrate of return allows the management to rank ventures by theirperformance (Abor,2017).Also, the internal rate of return method is easy to interpret aftercalculation.

Disadvantages

Internalrate of return method ignores the crucial concept of economies ofscale.

References

Abor,J. Y. (2017). Evaluating Capital Investment Decisions: CapitalBudgeting. In&nbspEntrepreneurialFinance for MSMEs&nbsp(pp.293-320). Springer International Publishing.