Question

When considering new projects some business owners want to know how quickly they will earn their money back (and use the Payback (PB) method or the discounted payback (DPB) method). Others want to know what the rate of return on the project will be and use the Internal Rate of Return (IRR) method). Still others want to know how the project will affect the value of their business (and use the Net Present Value (NPV) method).

Identify and describe the strengths and weaknesses of each of these four methods.

Which of them would you recommend as the best method? Explain why.

Answer 1

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.

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.
4. It gives multiple IRR when have more than one negative cash flows occur in the project

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

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

Strengths of Discounted Payback Period
1. Easy to calculate and calculate and less time consuming.
2. It includes time value of money and includes risk in cash flows.

Weakness:
1. doesn’t consider cash flows after Discounted Payback period.

NPV is best method because it gives accurate results in independent s well as mutually exclusive projects, includes time value, calculates for the entire project. The discount rate is WACC which can be practically calculated through capital structure of the firm.