Investment Appraisal Tools and Techniques - Essay Example

The decision rule based on this method is that, if the payback period of investment lies within the investor's required range of duration, the investment is considered. The method is simple to use. However, it ignores the concept of the time value of money (Damodaran 2008, pp. 277).

Net present value- in this method, both the cash inflows and outflows are discounted. The discounted outflow is subtracted from the sum of discounted cash inflows to obtain the net present value. The discounting rate is selected based on the cost of finance. According to this method, an investment should be accepted if the net present value is greater or equal to zero. Therefore, a company with a positive net present value is considered of more value. The proponents of this method assert that it is advantageous because it takes into account the time value of money. Secondly, it conforms to the objective of shareholder wealth maximization. Lastly, it takes into account all the cash flows. Therefore, it is really concerning the estimation of return on investment. On the other hand, opponents of the method assert that it is disadvantageous because it ignores the element of risk and the concept of payback period (Schön 2007, pp. 501).

The internal rate of return- IRR is the cost of capital of a company when the net present value equals zero. IRR of an investment can be obtained using trial and error, interpolation, and extrapolation methods. The fair value of a company is considered high if the IRR is higher or equal to the cost of finance. The proponents of this method assert that it is advantageous because it takes into account the concept of the time value of money. Secondly, it considers the cash flows over the entire life of a venture. Lastly, it is compatible with the maximization of the owner’s wealth. On the other hand, its opponents argue that it is difficult to use (Gildersleeve 1999, pp. 280-287)
Profitability index- it is the ratio obtained after dividing the sum of the present value of cash inflows by the initial cost of investment. A company whose PI > 1 is considered of high fair value and is suitable for investment. Investment is discouraged in companies whose PI < 1. Advocates of the method argue that it is easy to use and it acknowledges the time value of money. On the other hand, proponents of the method argue that it may be difficult to estimate if the economic life of an investment is long (Schön 2007, pp. 501).

Capital asset pricing model- the model states the relationship between the risk and return on assets in a diversified portfolio. Investors are risk-averse and prefer assets with lower risk at a given rate of return or higher return at a given level of risk (efficient assets). According to this model, it is profitable to invest in efficient assets. The model is limited because it relies on unrealistic assumptions. Secondly, it cannot practically experiment because it is impossible to test the investors’ expectations. Lastly, it assumes that the required rate of return of an asset is exclusively influenced by the market risk while other factors such as inflation also affect the rate of return of an asset (Giovanis 2010, pp. 97)

Similarities
From the above description, it is in order to say that all the above tools except CAPM and involve a company’s cash flow. Secondly, the NPV and profitability index is used in a situation that demands the recognition of the time value of money. Both the NPV and the IRR demand the determination of the cost of finance prior to any evaluation process. Lastly, both the NPV and the PI are compatible with the maximization of shareholders’ wealth (Hirschey 2009, pp. 122-127).

Differences
Unlike the NPV, IRR, PI, and payback period, the CAPM technique can be used even in the absence of cash flows. The only important feature in this technique is the determination of the rate of returns and risk level. Secondly, unlike the NPV, PI, and IRR, the payback period does not recognize the time value of money. Lastly, unlike the NPV, IRR, and PI, the CAPM and payback period do not involve the use of the cost of finance in the appraisal process. Read More