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To choose the right project the CEO should consider using the investment appraisal methods that allows the management team of the firm to evaluate a project based on the possible opportunity costs, returns, risks and payback period so as to determine the most suitable from a list of several such projects (Hacura, Hacura and Kocot, 2001).
These appraisal tools include; Internal Rate of Return (IRR), Non-discounted payback period, discounted payback, Net Present Value (NPV) and the Profitability Index (PI) (Hacura, Hacura and Kocot, 2001). Such evaluation tools collectively indicate the relationship between the return and risk, payback period and return (taking inflation into account) (Maslinski and Kettle, 2010).
For many years risk evaluation was an important hub for business providing powerful signs of possible outcomes; for instance, the CEO should accept the project because it has a positive NPV (Savvides, 1994), and the tax rate is 30% for the first two years and 28% in the remaining three years.
Besides, even based on the IRR the project should be accepted because the IRR is more than the company’s cost of capital of 15%. The project is still acceptable if based on the non-discounted payback and discounted payback if the cut off period is 5 years.
However, limitations at times influence investment decisions for example these tools of appraisal pose some shortcomings such as discounted payback appraisals can change uncontrollably while non-discounted payback does not consider “time value of money” (Maslinski and Kettle, 2010).
Other limitations include perpetual rates of growth, too large discount rates, the fair value earned by the firm may be incorrect, and inaccurate cash flow estimates (Maslinski and Kettle, 2010). Leading to circumstances where small variations in inputs may lead to huge variations in the firm’s value (Maslinski and Kettle, 2010).
References
Hacura, J., Hacura, M. and Kocot, A., 2001. Risk analysis in investment appraisal based on the Monte Carlo simulation technique. The European Physical Journal B, 20:551-53.
Maslinski, M. and Kettle, S., 2010. Hard lessons for business wealth managers. [Online](Updated 2010) Web.
Savvides, S., 1994. Risk analysis in investment appraisal. Project Appraisal, Vol.9(1):3-18.
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