STATISTICS AND QUANTITATIVE METHODS

Statistics and Quantitative Methods

Statistics and Quantitative Methods

Question 1 i

Payback Period

Payback period represents the time duration it takes to secure initial investment income of the project. It relates to recovering the investment spending money (Shapiro, 2005). Along with the net present value (NPV) and internal rate of return (IRR), it is used as a tool for evaluating investments. Payback period is an excellent indicator to determine the duration it takes to recover the initial cost.

Longer payback periods can be risky as there are many independent variables such as change in stocks market, global recession and political restrictions, which might have a dramatic result in revenues (Ehrhardt, 2010). Therefore, few investors prefer short payback period among projects as they recoup the initial investment sooner.

Question 1 ii

NPV

Net Present Value (NPV) is the most popular method when evaluating investment projects in the long term. The net present value determines whether an investment complies with the basic financial objective of maximizing investment or not.  If it is positive, it means that the value of the firm will have an increase equal to the amount of Net Present Value. If it is negative, this implies that the firm will reduce its wealth in the value yielding the NPV (Shapiro, 2005). If the result is zero NPV, the firm does not change the amount of its net worth.

Main reason for reluctant to invest is based on the potential weakness of the NPV modelling tool to determine the project viability (Ehrhardt, 2010). NPV does not take into account the role of uncertainty in business decisions. Considering the technical and technological uncertainty, NPV results may change that would lead to turning the project unfeasible based on change in return cash flows. The main limitation of the test comes from the discount rate used (Shapiro, 2005). 

Question 1 iii

Internal Rate of Return

The rate of return (IRR) is the most important ratio for investors because it measures the real return on capital invested. It represents the amount at which discounted value of capital employed and cash inflows (in sum, NPV) equal to zero (Shapiro, 2005). The rate of return is calculated without considering tax principles. Indeed, according to the profile of the company project, taxes can be quite different depending on the nature of the goods and their period of detention. For an investment project to be profitable, it is necessary that the IRR is greater than the rate of return required by the company (rejection rate). At equilibrium, the IRR is equal to the market rate, which suggests that net present value is zero (Creswell, 2009). 

Only the project can be considered feasible from the economic point of view if the net present value is positive. When there are two profitable compared to the net present value is the best way to determine the most feasible project. Single technique cannot be applied to assess the investment appraisal; combination of NPV, IRR, and Payback period should be used to assess the viability of the project based on risk associated with the project and desired return requirement of the company ...