As per CFI, will investment create or destroy company value?
Please respond by agreeing and adding facts to each individual in 2 separate paragraphs with a minimum of 175 words.
Example: (Paragraph 1) Marie, I agree with such and such….
Paragraph 2- Billie, I agree with such and such.
Here are their responses, (marie) Payback Period is apparently the most simplest method and easily understood, providing info on the years it takes for the firm to regain the funds expended on investment of a capital project (break-even point).
Discounted Payback Period provides the same as above but adding the established discounted rate so as to obtain the time value of money cash flows. According to CFI, “if the discounted payback period of a project is longer than its useful life, the company should reject project.” – https://corporatefinanceinstitute.com/resources/knowledge/finance/discounted-payback-period/
Net Present Value provides a longer term aspect of the likelihood a large capital project will be worth investing in through “discount of future cash flows back to present value” – https://www.extension.iastate.edu/agdm/wholefarm/html/c5-240.html#:~:text=They%20include%20the%20Payback%20Period,Modi%EF%AC%81ed%20Internal%20Rate%20of%20Return.
Internal Rate of Return is basically the expected return rate annually on a project investment. Per CFI, is is the discount rate that makes the NPV of a project zero – https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-return-irr/
Modified Internal Rate of Return provides accuracy to cost and profitability of a project; hence assumption of return to the actual cost of capital vs reinvest to IRR (above). Project is accepted if the MIRR is less than the expected return – https://corporatefinanceinstitute.com/resources/knowledge/finance/modified-internal-rate-of-return-mirr/
Profitability Index gives us a ratio that tells us whether or not a company’s future profit of cash flows can handle cost of project. As per CFI, will investment create or destroy company value? – https://corporatefinanceinstitute.com/resources/knowledge/accounting/profitability-index/
I believe that the Payback Period or Discounted Payback Period are typically used by smaller business such as starter who may not have much of cash inflows yet, or small capital project such as a type of machinery that a company needs in order to make a profit. Net Present Value would normally be utilized by larger firms with large assets such as major reconstruction of a shipping container vessel and long-term outlook perspective is needed.
PAYBACK PERIOD EXAMPLE
According to SoFi.com, there are two methods:
initial investment/yearly cash flow (average method)
the last year with negative cash flow + (amount of cash flow at the end of the year/cash flow during the year after that year)
I will use the first method above.
Investment of $200,000 for a new smaller size crane. Firm expects asset to generate $80,000 annually.
$200,000/$80,000 = 2.5 year payback period
or $200,000/$100,000 = 2 year payback period
Second option would be the better option since payback period will take less time than in first option.
Response from Billie, 1. Payback period (standard) – the payback period is the amount of time it takes to recover the amount that was invested into a project. For example, if I invested in a project and it is going to take seven years for me to recoup that investment, then my payback period is seven years.
2. Discounted payback period (modified from payback period) – the discounted payback is the time it takes to break even from an initial investment. It considers the time value of money where the payback period doesn’t.
3. Net present value (NPV) (standard) – net present value is a method used to calculate your return on investment for your project.
4. Internal rate of return (IRR) (standard) – the internal rate of return is the rate of growth an investment is expected to generate over an annual period. This calculation excludes any outside factors.
5. Modified internal rate of return (MIRR) (modified from IRR) – modified internal rate of return measures the financial attractiveness of an investment.
6. Profitability index (PI) (modified from NPV) – profitability index is used to measure project valuation and attractiveness. It is essentially a cost benefit analysis of a project.
For small projects, the best option is the payback method. This is the simplest method and can tell you very quickly the time it takes to gain on your investment and better for short term projects which tend to be smaller projects.
Most larger projects should use the profitability index. It not only measures the attractiveness of the project; it also additionally does a cost benefit analysis of the project. This is key for larger scaled projects to determine if the benefits outweigh the investment.