This means that the investor will choose the investment that offers the best risk-return ratio. It is believed that for the most part, investors tend towards risk aversion. Often, decisions are made under conditions of uncertainty, and in this situation they will use perceived risk as their guidepost rather than objective risk, as thought do not know the latter (ScienceDaily, 2010). Risk aversion is often assumed in financial modeling.
The most important thing about risk aversion, however, is that the degree of risk aversion is critical to setting the desired rates of return. The more risk averse an investor is, the higher the rate of return that will be demanded in order to undertake the investment. Thus, risk aversion is critical to the investment decision and to determining the rate of return that a project will require.
6. There are a number of different techniques for solving problems that involve time value. The first is the breakeven point or payback period. This analysis helps to determine when the project will break even. The idea behind this is that the faster the investment pays for itself, the better the investment is. The worry is that investments which do not pay until well into the future are riskier, because there is less certainty associated with those cash flows.
The second method is the internal rate of return. This technique is based on the assumption that the IRR must be greater than the discount rate. This reflects the idea that the returns associated with the project are going...
In order for a project to be accepted, the IRR needs to be higher than the discount rate. The IRR itself is based on the expected future cash flows, relative to the costs related to the project.
The third method is net present value. The NPV reflects the sum total value of the future cash flows associated with the project. These are converted to present dollars via the discount rate. This method is related somewhat to IRR in that a project with an IRR above the discount rate is going to be a project that has a positive net present value. The difference is that whereas IRR is mostly useful as a single-project evaluation tool, NPV can be used to evaluated multiple projects that are mutually exclusive. The project with the highest IRR might not be the project that adds the most value to the organization, particularly if it has a much smaller initial investment.
These different techniques each have their merits and their drawbacks, so many companies will use more than one of them to help understand the value of their investments in the future. It is recommended that each be calculated and then to let the circumstances determine which is the best project evaluation method featuring the time value of money.
Works Cited:
Investopedia. (2011). Dividend discount model. Investopedia. Retrieved May 13, 2011 from http://www.investopedia.com/terms/d/ddm.asp
ScienceDaily. (2010). The psychology of financial decision making and…
