Course Level: Intermediate and Advanced - Since this course goes beyond traditional capital budgeting analysis, it is recommended that users have an understanding of capital budgeting prior to taking this course. Recommended for 2.0 hours of CPE.

Asset Management Ratios

We have completed our three main stages of capital budgeting analysis, includingcalculating asset management ratios calculation of discounted cash flows. learning asset management ratios analysis, online coursenext step is to apply some economic criteria for evaluatingcalculating asset management ratiosproject. We will use three criteria: Net Present Value, Modified Internal Rate of Return, and Discounted Payback Period.

Net Present Value

learning asset management ratios analysis, online coursefirst criterion we will use to evaluate capital projects is Net Present Value. Net Present Value (NPV) iscalculating asset management ratiostotal net present value of the project. It represents the total value added or subtracted fromcalculating asset management ratiosorganization if we invest in this project. We can refer back to our previous example and calculate Net Present Value.

Ifcalculating asset management ratiosNet Present Value is positive, we should proceed and make the investment. If the Net Present Value is negative (as iscalculating asset management ratioscase in Example 10), then we would not make the investment.

Modified Internal Rate of Return

Besides determiningcalculating asset management ratiosNet Present Value of a project, we can calculate the rate of return earned by the project. This is calledcalculating asset management ratiosInternal Rate of Return. Internal Rate of Return (IRR) is one ofcalculating asset management ratiosmost popular economic criteria for evaluating capital projects since managers can identify with rates of return. Internal Rate of Return is calculating by finding the discount rate wherebycalculating asset management ratiosNet Investment amount equals the total present value of all cash inflows; i.e. Net Present Value = 0. If we have equal cash inflows each year, we can solve for IRR easily.

Ifcalculating asset management ratiosInternal Rate of Return were higher than our cost of capital, then we would accept this project. In our example, calculating asset management ratiosIRR (6.43%) is less than our cost of capital (12%). Therefore, we would not invest in this project. One ofcalculating asset management ratiosproblems with IRR is the so-called reinvestment rate assumption. IRR makescalculating asset management ratiosassumption that every year you will be able to earn the IRR each time you reinvest your cash inflows. This assumption can result in some major distortions between Net Present Value and Internal Rate of Return. We will correct this distortion by modifying our IRR calculation.

In order to eliminate the reinvestment rate assumption, we will modify calculating asset management ratiosInternal Rate of Return so thatcalculating asset management ratiosreinvestment rate is our cost of capital. This will give us a more accurate IRR for our project. Fortunately, we can use spreadsheets like Microsoft Excel to calculate Modified Internal Rate of Return.

Discounted Payback Period

learning asset management ratios analysis, online coursefinal economic criteria we will use is the Discounted Payback Period. Payback refers to the number of years it takes to recover our net investment. In our previous example (Example 6), we could use a simple payback calculation as follows:

$ 24,100 / $ 5,788 = 4.2 years

However, this method does not recognizecalculating asset management ratiostime value of money and as we previously indicated, we must considercalculating asset management ratiostime value of money because of inflation, uncertainty, and opportunity costs. Therefore, we will use the discounted cash flows to calculatecalculating asset management ratiospayback period (discounted payback period).

Undercalculating asset management ratiosDiscounted Payback Period, we would never receive a payback on our project; i.e. calculating asset management ratiostotal to date present cash flows never reached $ 24,100 (net investment). If we had relied on the regular payback calculation, we would falsely assume that this project does payback incalculating asset management ratiosfourth year.

In summary, we use economic criteria that have realistic economic assumptions about capital investments. Three economic criteria that meet this test are:
  • Net Present Value
  • Modified Internal Rate of Return
  • Discounted Payback Period

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