The Use of Financial Tools in the Management Process - Term Paper Example

? Internal Rate of Return December 8, Introduction The enhancement of the decision strategies includes the use of financial tools. There are several tools used in the management process (Warren, 2011). One of the tools relates to how many regular periods will the investment be recovered. The internal rate of return tool enhances the decision making process. Internal Rate of Return Concept The internal rate of return (IRR) is one of the popular tools used in managements’ decision making activities (Moyer, 2009). The tool shows the real economic return of a project or investment alternative. Investments have related interest expense amounts. The same return shows the interest rate that is used to generate a resultant zero net present value. The present value is arrived at by using an interest rate in the computation. The annual or periodic cash inflow is collected. Examples of inflows of cash are: ? 260 for year 1, ? 280 for year 2, ? 250 and for year 3. The interest rate is given. The periodic or annual inflows of cash are multiplied by the present value factor (interest rate). The result of the multiplication activity is the present value amount of the periodic inflows of cash (Hilton, 2011). To computation of the rate of internal return, the present values are determined. Next, the decision maker must equate the cost of the investment as the total inflows of cash. Subtracting the two accounts, the net present value is nil (Daft, 2011). Next, the internal rate of return can be easily computed (Sollenberger, 2008). The total present value of net inflows of cash is divided by the total inflows of cash. The computation outcome is traced is plotted on the net present value table. The decision maker searches for the column where the division result falls. The interest rate is traced by looking at the period row of the net present value table. If the equipment is used for 5 periods, the decision maker looks for the column where the computation result appears within the 5 period row. If the division generates a 5.867 result for a 5-year equipment, the present value table shows that the 5.867 figure on the 5 period row appears under the 8 percent column. Thus, the internal rate of return (IRR) is 8 percent (Wright, 2008). Further, the internal rate of return (IRR) tool is used to compare the financial performance of two or more entities. For example, the internal rate of return of Reagan Company is 6 percent. Further, Washington Company has an internal rate of return of 8 percent. Comparing the two companies’ internal rate of return, Washington Company has a better internal rate of return. The company with the higher internal rate of return output shows a financially better business image (Gitman, 2008). Compared with the net present value decision making tool, the internal rate of return is a better management tool. Most decision makers prefer the internal rate of return. The internal rate of return places importance on times’ effect on money, cash flows. Time value analysis includes placing higher value on the earlier collection or payment of cash amounts over the same amount of cash collected at later years. Second, average decision makers can use the simpler internal rate of return analysis for their decision making activities. The same return analysis eliminates subjective inputs injected into the analytical process (Besley, 2008). For those who are not well versed in financial analysis, the internal rate of return is one of the best decision references. The rate can be subjected to the decision makers’ subjective analysis. Many decision makers, including John right of Citigroup, insist they will only approve projects if the internal rate of return is higher than the cost of capital rate (Megginson, 2008). If the internal rate of return rate is higher than the cost of capital rate, the companies can recuperate their investment costs. Comparing Internal Rate of Return with other decision making tools Net Present Value. For decision makers who are not knowledgeable in business mathematics, the IRR is easier to comprehend than the net present value decision making tool. The net present value is another popular decision making tool. The decision maker compares the present value of all inflow of cash with the cost of investment. If the present value of the total inflow of cash is greater than the cost of the investment, the company should proceed with the project. The company must not push through with a project generating negative net present values. Based on the prior paragraphs’ internal rate of return discussions, the internal rate of return is an easier decision making tool than the net present value. For example, Prime Minister Brown buys a ? 2,500 factory machine. The machine’s total ten year $ 2,600 inflow amounts to a meager ?2,600. Deducting the total cost of the equipment (? 2,500) from the total ? 2,600 inflow of cash, the big company acquires valuable amount amounting to ? 100. Prime Minister Brown should implement the investment (Hilton, 2011). Profitability Index Tool. The internal rate of return tool is better than the profitability index tool. The profitability index shows the relationship between the net present value of the inflow of cash and the investment amount. The profitability index formula is: net present value of inflow of cash / initial investment. The profitability index tool gives a picture that the constraints apply only to the current period. The tool ignores future investment possibilities (Brealey, 2011). Payback Period. Additionally, the payback period differs from the internal rate of return tool. The payback period unfavorably uses subjectivity in the decision making process. Usually, the payback period does not take into consideration the time value of money. Instead, the tool uses actual annual inflow of cash in the decision making process. Consequently, the internal rate of return is a better decision making tool than the payback period tool (Hilton, 2008). Limitations of Internal Rate of Return Tool The internal rate of return tool has its glaring limitations. First, the tool does not focus on how inflows of cash are acquired. The inflow of cash may include higher investment costs, finance charges. Second, the decision makers may find the internal rate of return tool too tedious when the periodic inflows of cash differ. Different inflows of cash include both positive inflows and negative inflows of cash, creating unrealistic internal rate of return outcomes. Third, the same tool uses the time value of money in the computation, unlike the payback period and other decision making tools (Epstein, 2012). Conclusion The improvement of management decisions requires the timely incorporating relevant tools. The complex net present value tool explains projects generating positive net present value results should be pursued. The rate of internal rate is arrived at through the use of both the present value amounts and the investment figures. The profitability index tool indicates the relationship between the present value of the inflows of cash and the investment cost. The above internal rate of return discussion shows that investments with higher interest rates are prioritized. The net present value similarly uses both the investment figure and the present value amounts. Overwhelmingly, the internal rate of return tool significantly improves the decision makers’ capital budget analysis. References: Besley, S., 2008. Essentials of Managerial Finance. London: Cengage Learning. Brealey, R., 2011. Principles of Corporate Finance. London: McGraw-Hill Press. Daft, R., 2011. Management. London: Cengage Learning Press. Epstein, M., 2012. Advances in Management Accounting. London: Emerald Press. Gitman, L., 2008. Principles of Managerial Finance. London: Addison Wesley. Hilton, R., 2011. Managerial Accounting. London : McGraw-Hill Press. Megginson, W., 2008. Introduction to Corporate Finance. London: Cengage Learning. Moyer, R., 2009. Contemporary Financial Management. London: Cengage Learning. Sollenberger, H., 2008. Managerial Accounting. London: SouthWestern Press. Warren, C., 2011. Managerial Accounting. London: Cengage learning Press. Wright, C., 2008. Fundamental of Oil & Gas Accounting. London: PennWell Books . York, N., 2010. Handbook of Decision Making, London: J. Wiley & Sons. Read More