The two basic issues associated with an investment decision are its feasibility and its desirability.
Feasibility refers to the ability to actually access the necessary capital and complete the project. Clearly an investment could promise highly desirable levels of returns, but simply be infeasible in terms of the initial cash flow requirements -- the simplest illustration of a budget constraint. Alternatively, an investment may be affordable and completely feasible, but the returns could be so low as to make the investment alternative unattractive. In the examples which follow, it is shown how investments can be evaluated in the context of both returns and cash flow feasibility.
There are a variety of ways by which one can evaluate returns on investment options. Five of
the most common are:
(1) net present value method,
(2) internal rate of return methods,
(3) profitability index or Q methods,
(4) payback or breakeven period methods,
(5) the average rate of return on investment.
A study in Financial Management indicated that the capital budgeting practices employed most by large firms to make decisions were internal rate of return methods (88%) and net present value methods (63%).1 Both the payback and the average rate of return approaches fail to account for the time value of money. And, the profitability index simply a variant of the NPV approach that is used to control for size effects. Consequently, the following discussion focuses on net present value and internal rate of return methods of evaluating investments. These two methods are the most commonly employed in practice, both account for the time value of money, and together they provide the most meaningful decision making information in investment analysis and capital budgeting situations.
Information Needs
The following information is needed to evaluate investments using time value of money concepts:
(1) the expected net after-tax cash flows (NATCF, or ATNCF) for the investment by period including a salvage value, if any,
(2) an appropriate interest rate or discount rate,
(3) the length of planning horizon,
(4) terms of financing if borrowed funds are used,
(5) the marginal tax bracket of the borrower, and the taxability status for each cash flow.
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