Businesses use a variety of techniques to evaluate capital investments. Many of these techniques calculate a net present value (NPV). Net present value calculations consider the value that money will have in the future. A company needs to identify the interest rate it requires when making an investment. This interest rate needs to exceed the rate at which it borrows funds. A company also uses the number of periods until it realizes cash flows. The company uses present value tables where it looks up the interest rate and the number of periods to find a multiplier. It multiplies this value by the dollar of the cash flow to determine the present value. NPV techniques include calculating the current value of an investment and ranking investments.
1. List each NPV technique at the top of the page.
2. Add up the cost of implementing each technique. Include labor hours and technology costs. Write the total cost underneath each technique heading.
3. List the benefits of using each technique underneath each technique. Possible benefits include calculating the total dollar value or each technique’s ranking capability.
4. List the limitations of each method. These include the inability to rank investments or reliance on estimates.
5. Cross out each method with limitations that make the technique unable to meet the company’s needs.
6. Rank the importance of the benefits listed for the company. Identify the methods with the most benefits as the most useful techniques for the company.
- Enlist the assistance of financial employees who evaluate financial analysis. These employees bring their experience and knowledge of analyzing investments.
- Don’t rely on a single evaluation technique when considering investments. NPV techniques represent one type of evaluation technique. Other evaluation techniques include calculating the payback period or the internal rate of return. Each evaluation serves a different purpose for the company. The best approach uses several techniques and compares the results.
- Net present value techniques rely on the company’s ability to estimate future cash flows of the investment. Actual cash flows may vary from estimated cash flows. When you consider which net present value techniques to use for evaluating investments, recognize that the actual performance of the investment can vary from the projected performance.
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