Question

List , Explain and give advantages and disadvantages of the following methods

a.Pay back Period

b.Accounting Rate of Return

c.Net Present Value

d.Profitability Index

e.Internal Rate of Return

Answer 1

a. Strengths of Payback Period
1. Easy to calculate and less time consuming

Weakness:
1. It doesn’t consider cash flows after Payback period.
2. It does not include time value of money.

b Advantages of ARR
1. It is easy to calculate and to understand also.
2. It takes into consideration net income which is ignored by other factors.
3. It does not include time value of money.

Disadvantages
1. net income can be different for different accounting practices.. Hence it is prone to manipulation
2. Depreciation and other non cash expense are not taking into consideration even through there is no actual cash outflow

c. NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow/.
3. It is good in evaluating project involving large investment is of large scale projects.
4. Here reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects.
Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.


d. Advantages of Profitability index
1. Helps in choosing projects based on scale of project .
2. It helps to identify projects with low NPV but profitability. This is particularly helpful when sources of fund are less.

Disadvantages:
1. It might reject high NPV projects in mutually exclusive projects.
2. cannot help to identify projects with different lives.



e. IRR:
Advantages:
1. Includes time value of money.
2. Good in accepting independent projects.

Disadvantages
1. Is not good for acceptability with large scale projects where it might be rejected when comparing with small scale project if IRR is higher.
2. IRR and NPV may conflict in certain case where NPV rule Prevails.
3. IRR rate is higher than WACC generally so reinvestment as higher than WACC may not be possible always.