MEASURING PROJECT PROFITABILITY: RATE OF RETURN OR PRESENT VALUE?
The profitability of a proposed investment is usually a major factor in deciding whether or not the investment should be undertaken. Since profitability depends on both the amount and the timing of the returns from the investment, it is becoming increasingly recognized that the "discounted cash flow" technique, which takes account of both those factors, is the most appropriate method of assessing profitability. The first step in applying discounted cash-flow to an investment proposal is to convert all the economic data about the proposal into a series of cash flows. Capital expenditures and operating losses are recorded as negative cash flows, operating gains and capital receipts as positive flows. The management of a healthy enterprise will encourage the development of a greater volume of profitable investment proposals than it is able to undertake. In selecting the most attractive of these proposals for implementation, profitability will usually be given considerable weight. Profitability should be assessed by reference to the cut-off rate which represents, under the conditions described, the opportunity cost of funds. Economic choice between mutually exclusive projects should be made by discounting them at the cut-off rate and selecting the project which yields the highest present value. The cut-off rate will be determined by the interaction of management objectives and policies in various fields. The cost of new funds and the interests of existing stockholders should set a floor below which the cut-off rate must not be allowed to fall, but as yet this floor level cannot be defined too precisely.
- DOI
- 10.2308/tar-7098776
- Volume
- 37 (3)
- Pages
- 433-437
- Language
- en
- Export
- BibTeX
- Sources
- openalex crossref