Question

Briefly compare and contrast the NPV, PI and IRR criteria. What are the advantages and disadvantages of using each of these methods?

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.

Assumptions:
1. the reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same

Improvement:
1. It can be improved by adding extra risk premium on WACC and estimating cash flows meticulously.

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

Assumptions:
1.Reinvestment rate is same as IRR which may not be practical.
2. Two different projects, even if equally risky, have two different reinvestment-rates

Improvement:
1. It can be improved by adding extra risk premium on WACC and estimating cash flows meticulously.

PI :
Advantages:
1. It factors in time value of money.
2. It helps in choosing project when there is constraint in initial investment.
3. It accounts for the risk in the project.
Disadvantages:
1. It doesnot include sunk cost
2. It doesnot give information about the scale of the increase in value of the firm due to a project.
3. It doesnot help in choosing from projects with different lives.

Assumptions:
1. the reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same