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Investment Analysis And Social Cost Benefits

 Investment Analysis and Social Cost Benefit

Introduction

            Investment analysis is concerned with helping a corporate manager to make better use of his limited resources so as to obtain competitive advantage over other firms. With the limited resources, he must take decisions about resource allocation. Frequently, these decisions are complexities given a very long period between the initial capital investment, the recovery of cost and earning of profit. Hence, the manager requires a decision rule that separates those investments that are worth making from those that are not.

            For this he selects a criterion which he will apply to find out the worthiness of a proposal. When he selects a criterion for acceptance or rejection of different investment proposals, he rejects unprofitable proposals. The rest proposals or projects are then taken upon the availability of funds. If the funds are limited with the firm, the most profitable projects are undertaken for execution.

Evaluating and Ranking of Investment Projects

            There are various methods of evaluating and ranking relative profitability of investment projects and we are going to discuss four of them are that grouped below.

  1. Pay Back Period Method
  2. Average Annual Rate of Return
  3. Net Present Value
  4. Internal Rate of Return
  1. Pay Back Period Method – PBP

    The payback period method is concerned with the recoupment of the original investment made in a project. It lays emphasis on calculating the length of time it would take to recover the actual investment. It involves calculation of the cash flows which would arise from investment in each year of the life of a project. These cash flows are accumulated year by year till the time they equal amount of the original investment made in the project.

    The length of time it takes to obtain the necessary cash flows equal to the original investment, determines the pay back period for the project. PBP is also used to rank projects. For instance, projects which repay within 3 years are preferred to those which take longer to pay back.

    The formula for ascertaining the payback period is as under
               
             Initial Investment    
             Annual Cash Inflow

Illustration 1
     
      A project requires an annual investment of $50,000 and is expected to generate an annual cash inflow of $10,000 for 10 years. Determine the Payback period.

            Payback Period           P          =          C
                                                                        A1

            Where, P is payback period, C is Initial investment or the cost of capital project and A1 is the Annual Cash Inflow.

            Hence,             P          =         50,000             =          5
                                                            10,000

            Thus, Payback period of this project is 5 years.

  1. Average Annual Rate of Return

    This method is based on the following concept of return on investment or rate of return. It refers to the percentage of the annual net income earned on the average funds invested in a project. The annual return of a project is the percentage of net investment in the project. It can symbolically be expressed as follows:

    AARR             =                      Average Annual Return                      x 100
                                           Average Investment in the Project

Illustration 2

Let us assume the average annual return of a project is $20,000 whilst the initial cost of project is $250,000. Determine the annual rate of return.

      AARR             =          20,000
                                         250,000

                              =          8%

Hence, Average annual rate of return is 8%

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