Financial Analysis

2293 words - 9 pages

MN20009 Corporate FinanceAll firms need to invest in order to grow. Investments generally require significant and irrevocable commitments of finance, whilst also being generally on a long-term basis. In order to decide on which project to take up, firms must undertake a screening process known as 'investment appraisal' to justify potential suitability. There are four main methods of investment appraisal: the Net Present Value (NPV) rule, the Internal Rate of Return (IRR), the Accounting Rate of Return (ARR), and the Payback Period.The basic characteristics of these four methods will be outlined and then compared.The NPV RuleThe NPV rule states that a project should be undertaken should its NPV be positive (Ross et al, 2005). It, like the IRR, is a discounted cash-flow (DCF) model because it takes into account cash flows, whilst discounting them instead of just adding them up (all formulae included in appendix). Due to this, it takes into account the time value of money, which helps to negate the effects of inflation. Although inflation is not directly a cash flow, it has an effect on tax and this is then added onto the cash flows themselves.The NPV rule also includes the cost of capital (or the discount rate); helping to take risk into account and covering any uncertain cash flows that may arise. It only includes the relevant costs, and it only takes these costs when they occur. The aim of any firm is to maximise its market value, and a positive NPV increases the value of the firm, helping to maximise shareholder wealth.The NPV rule has three key advantages in that it uses cash flows instead of earnings, it uses all the cash flows of a project, and it discounts the cash flows with regards to the time value of money. Other forms of investment appraisal tend to ignore at least one, if not more, of these points. The NPV rule also provides a clear rule over the acceptance or rejection of a project.However, only future costs are taken into the analysis. This means that past costs are ignored because they do not vary with future decisions. There is also a heavy reliance on the discount rate, often difficult to calculate, and as a result, the cash flows can be complicated to predict. Cash flows are usually assumed to take place at the end of each year, but in practice, this is an over-simplification of the issue (Irons, 2004).The Internal Rate of ReturnThe IRR is the most similar to the NPV rule, because it is also a DCF method. The IRR is the value where the discount rate would produce an NPV of zero. It does not depend on extrinsic factors such as interest rates; it merely focuses on the cash flows of the firm itself. The general rule of thumb is that projects with an IRR greater than the discount rate should be accepted, and projects with a discount rate higher than the IRR should be rejected.This method is popular because of its ease of understanding, and it concerns one variable and not two, such as in the case of the NPV rule. The IRR summarises...

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