Database Reference
In-Depth Information
3.1.5 Profitability Index
The profitability index attempts to identify the relationship between the costs and benefits of the
project through the ration calculated as
PresentValue of Cash Flows
Investment
=
ProfitabilityIndex
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 financial attractiveness of the proposed project.
3.1.6 Internal Rate of Return (IRR)
The IRR calculates the rate of return that an investment is expected to earn, taking into consid-
eration the time value of money. The higher is the project's IRR, the more desirable it is to carry
out the project.
Internal rate of return (IRR) is a capital investment measure that indicates 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.
For the NPV method, we assume that the generated cash flows over the life of the
project can be invested elsewhere, at a rate equal to the cost of capital, as the cost of
capital represents an opportunity cost. The IRR, on the other hand, assumes that
generated cash flows can be reinvested elsewhere at the internal rate of return. The
larger the IRR in relation to the cost of capital, the less likely that the alternative returns can
be realized; hence, the underlying investment assumption in the IRR method is a doubtful
one, whereas for NPV, the reinvestment assumption seems more realistic. In the same way,
the NPV can accommodate conventional cash flows, whereas in comparison, we may get
multiple results through the IRR method.
If a company has several competing cloud computing projects, the IRR can be used in
selecting which project to prioritize.
3.1.7 Economic Value Added (EVA
™
)
Economic Value Added (EVA), also known as economic profit, is a measure used to determine
the company's financial performance based on the residual wealth created. It depicts the investor
or shareholder value creation above the required return or the opportunity cost of the capital. It
measures the economic profit created when the return on the capital employed exceeds the cost
of the capital. Reducing costs increases profits and economic value added. Unlike ROI, economic
value added takes into account the residual values for an investment.
