Thursday 15 December 2016

Determining a Satisfactory Investment

Time value of money techniques can be used to determine whether an investment's return is satisfactory given the investment's cost.

Ignoring risk at this point, a satisfactory investment would be one for which the present value of benefits (discounted at the appropriate discount rate) equals or exceeds its cost.



The three possible cost-benefit relationships and their interpretations follow:

1.  If the present value of the benefits equals the cost, you would earn a rate of return equal to the discount rate.

2.  If the present value of benefits exceeds the cost, you would earn a rate of return greater than the discount rate.

3.  If the present value of benefits is less than the cost, you would earn a rate of return less than the discount rate.



You would prefer only those investments for which the present value of benefits equals or exceeds its cost - situations 1 and 2.

In these cases, the rate of return would be equal to or greater than the discount rate.

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