Internal rate or return, Net present value, Present Value, Furture Value

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Internal rate or return, Net present value, Present Value, Furture Value

Category: Research Paper

Subcategory: Finance

Level: College

Pages: 3

Words: 825

Internal Rate of Return, Net Present Value, Present Value, and Future Value
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Internal Rate of Return, Net Present Value, Present Value, and Future Value
Internal Rate of Return (IRR)
The internal rate of return (IRR) is a measure used by organizations to determine the investment returns of a project. IRR is the discount rate that guarantees a net present value of zero for investment. Managers compare the internal rate of return of investment with the minimum required a rate of return to determine the viability of an investment. Projects and investments that indicate a positive IRR are considered viable. Additionally, while comparing the profitability and the viability of many investment opportunities, organizations choose the project with the highest IRR (Rohrich, 2007). Therefore, internal rate of return can be used to determine the viability of a project as well as compare several projects to determine the best course of action for an organization.
The projected return on investment takes into account the value for money over time. IRR provides the expected return over a specific time, which makes it essential for short and long term planning (Rohrich, 2007). However, several IRR can exist for a single investment, thus making it difficult to analyze the cash flows. The use of IRR to determine the investment viability of a project is less effective than the use of Net present value (NPV) comparatively. For instance, in the case of multiple investments, the use of IRR can mislead the organization by choosing a project with the highest IRR rather than the project that would produce the highest NPV. IRR assumes a constant amount of NPV, which is not always true for many investments. Therefore, instead of looking at the rate of return at a zero NPV, organizations should choose projects that predict a positive and higher NPV for profitability.
Net Present Value (NPV)
Net present value is the difference between the present value of cash inflows and the present value of cash outflows. NPV is often used in capital budgeting to determine the profitability of a business. In most cases, NPV is used interchangeably with IRR and payback period to determine the profitability of a projected investment. Unlike other metrics used in the determination of project future profitability, NPV takes into account the changes in monetary value over time. Money may rise or fall in value as time progresses; therefore, it is vital to take into account such changes when determining the profitability of an investment (Kendrick, 2006). Considering the changes in the value for money helps to calculate the cash flows effectively, thus providing an ideal result.
A positive NPV indicates that the projected earnings of a project will exceed the project cost of the same. Managers use the projected cash flows to determine the possible NPV at the present value of money. Additionally, NPV calculations take into account the possible risks that might affect the business, hence, the best metric to determine the viability of a project. However, NPV has multiple assumptions some of which may be adjusted to attract investors. The rate used to discount future cash flows determines the amount of risk incorporated in the metric to determine the profitability of the business (Kendrick, 2006). Based on the many assumptions of the metric, it is wise to use NPV in combination with either IRR or payback period to accurately determine the profitability of an investment.
Present Value (PV)
Present value is a metric used to determine the amount of money required to produce a certain amount of money in the future at a certain interest rate. In other words, present value is the inverse of future value where a future amount of money is discounted to determine its value presently. For instance, if a person wanted to earn 50 million dollars in a period of three years at the interest rate of 10%, the expected amount (50 million) is discounted at the rate of 10% for three years to determine the right amount of money to invest. The metric is used to determine the right investments for either individuals or organizations by looking at the future. Both present value and future value have almost similar functions in accounting and are similar in many stances. They both use cash flows, interest rates, and time to determine the value of money (Ackerman, 2013). However, the use of present value in determining the value of money is more accurate because it helps investors to put their money to better use and avoid bearing unnecessary opportunity costs.
Future Value (FV)
Future Value is the determination of the value of money after a given time at a certain interest rate. While the present value uses the value of money in the future to determine its value presently, the future value uses the present value of money to determine future value. The use of future value helps investors to determine the best projects in which to put their money to achieve the highest rate of returns (Ackerman, 2013). However, since the calculation of future value does not take into account the inflation rates and other economic factors that can affect investment, it is better to use NPV to determine the best investment option. The capitalization process is only effective for short-term investments.

References
Ackerman, L. (2013). Blackwell’s five-minute veterinary practice management consult. Ames, Iowa: John Wiley & Sons, Inc.
Kendrick, T. (2006). Results without Authority controlling a project when the team does not report to you. New York: AMACOM.
Rohrich, M. (2007). Fundamentals of Investment Appraisal: An Illustration Based on a Case Study. Munchen: Oldenburg.