Information Technology Reference
In-Depth Information
First, the present value is calculated as
(
)
n
Payment 11interest
Interest
= −+
leading to
(
)
Net Present ValueNPV
=
Present Value of Expected Cash Valu
ee nitial Investment Costs
14.1.1.4 Cost-Benefit Ratio
This calculation method views the total benefits of an investment over the
costs consumed to deliver these benefits:
Total benefits
Total costs
Cost benefit ratio
=
14.1.1.5 Profitability Index
The profitability index attempts to identify the relationship between the
costs and benefits of the project through the ration calculated as
Present value of cash flows
Investment
Profitability index
=
The lowest acceptable value of profitability index is 1.0; any value lower
than 1.0 would indicate that the project's present value is less than the initial
investment. As values of the profitability index increase, so does the finan-
cial attractiveness of the proposed project.
14.1.1.6 Internal Rate of Return (IRR)
The IRR calculates the rate of return that an investment is expected to earn,
taking into consideration the time value of money. The higher is the project's
IRR, the more desirable is it to carry out the project.
Internal rate of return (IRR) is a capital investment measure that indi-
cates how efficient an investment is (yield), using a compounded return
rate. If the cost of capital used to discount future cash flows is increased,
the NPV of the project will fall. As the cost of capital continues to increase,
the net present value will become zero before it becomes negative. The IRR
is the cost of the capital (or a required rate of return) that produces an NPV
of zero.
 
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