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Strategic Investment Decisions - Literature review Example

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The goal of this document "Strategic Investment Decisions" is to discuss several methods of appraising investments. The discussion presents an overview of ways of discounting the cash flows to arrive at an acceptable criterion of investing funds in the business…
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Strategic Investment Decisions
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Download file to see previous pages The Discounted Cash Flow (DCF) method is one of the more common investment appraisal techniques. It has been adopted by and followed at many companies since it takes into account the fundamental fact of financial accounting i.e. the time value of money. Simply put, it means that a dollar today is different in value from a dollar tomorrow (Bazerman, 1998). The DCF method is comprised of three different ways of discounting the cash flows to arrive at an acceptable criterion of investing funds in the business. These methods are; Internal Rate of Return (IRR), Net Present Value (NPV), and Discounted Payback Period (Arnold, 2002).
The internal rate of return (IRR) is the rate of return (or the rate of discount) which would make the discounted present value of the expected future returns of investment exactly equal to the current cost of the investment (Arnold, 2002). The internal rate of return reduces the present value of the investment to the present value of its cost so that the net yield would be zero. In economic literature (Bazerman, 1998) the internal rate of return is called by the ‘marginal efficiency of capital’.
If 10 percent is taken as the trial discount rate, it is seen to be just right, as the present value of the future yield of 10 is exactly 100 which is equal to the present cost so that the net present value of the investment is zero, and 10 percent is, therefore, the internal rate of return in this example. This is the central advantage of the system since by using a process of iteration; it is possible to find that exact rate of interest which makes the present value of the net returns equal to zero (Bazerman, 1998).  As long as the internal rate of return exceeds the rate of interest at which funds can be borrowed (cost of funds), it is profitable to undertake the investment. As such, it makes the appraisal of any investment a manageable task.  ...Download file to see next pagesRead More
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