Question

Please discuss the pros and cons of all methods (payback period, NPV, IRR) that we can use to decide whether the project can be executed or not. Please explain which method is best and the reason for your choice.

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.

NPV is best method because it gives accurate results in independent as 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.