Time Value of Money Calculations Assignment Example | Topics and Well Written Essays - 750 words

Time Value of Money Calculations - Assignment Example Capital budgeting decisions are based on an evaluation of the cash flows expected from investing in a specific project (Emery et al 2007). Projects are evaluated using methods such as: net present value (NPV), internal rate of return (IRR), payback period (described as simple payback) and discounted payback period. These methods can assist management in deciding which project among a set of options yields the best return or whether a particular project should be undertaken. The NPV is the net balance of the initial investment after deducting future cash flows at present values. The implication of a negative NPV indicates the failure of the project to generate enough funds to pay up the initial investments as well as to facilitate some returns to shareholders. Information contained in the Appendix indicates that the project has a positive NPV of $16,692. This implies that the project would be beneficial to the organization The IRR is the discount rate that equates the present value of a project’s cash flows with the cost of the project (Brigham and Ehrhardt 2005). This occurs when NPV is equal to Zero (0). If used appropriately it is a valuable tool in the selection of projects (Hazen 2003). The IRR of the Server Update project is 10.13 per cent. This is 2.13 per cent above the organization’s cost of capital and therefore offers a positive return to shareholders. See Appendix 1 for the solution. According to Brigham and Ehrhardt (2005) the simple payback period indicates the time period over which the project recovers the initial investment. In performing the calculations the annual cash flows are set off against the initial outflow until there is a positive balance. Investments with long payback periods are considered to be risky compared to those with relatively short payback periods and so this method has a bias for short term projects. Additionally, the simple payback method does not take into account the time value of money since it