Question

In your own words Specifically, provide an explanation of payback period, IRR, MIRR and NPV. Also, explain how business’ use these for decisions and the potential advantages/disadvantages of each.

Answer 1

NPV (Net Present value) Method is one of the most popular methods used for capital budgeting decisions. In this method, cash flows received in the future are discounted with the required rate to determine the present value. This present value is compared with the cost of the project. It the present value is more than the cost of the investment, then the proposal is accepted. It helps in calculating returns in absolute terms. It helps in solving capital rationing problems. It considers the wealth maximisation aspect too. IRR method helps us in calculating the rate which is internal to a given project for discounting various cash flows accruing from a project. It is the rate which equates the present value of cash inflows to the present value of cash outflows. Projects are accepted when IRR is greater than or equal to the minimum rate of return. However, this technique is based upon reinvestment rate assumption which is not in the case of NPV. It is complex to calculate as compared to simple NPV. MIRR method also helps in calculating the internal rate of return. The only difference (on comparing with IRR) that MIRR considers is the cash flows are reinvested at the cost of capital and the outflows are financed at the firm's financing cost. MIRR is better as compared to IRR since the problem of multiple IRR's is solved. Also, the issue of reinvesting at IRR is also solved by MIRR.  Payback Method calculates the time period to recover the original investment of the project. This method is highly simple but with a major drawback. It doesn't consider the time value of money which has so far been considered by NPV, IRR and MIRR.

If there is only one project and it is to be decided whether it should be selected or not then its NPV is calculated. Projects with the Negative NPV are generally rejected. All projects are accepted when IRR is greater than or equal to the minimum rate of return. When IRR Method results in multiple IRR's, MIRR Method is preferred. In case of Payback Period, project is accepted if the payback period is less than maximum payback period.