Question

Explain why there are differences and discrepancies in the recommendations of the four selection criteria. ( NPV , IRR , Pay back period and Profitability Index )

Answer 1

Lets discuss a few Benefits and Discrepancies for all the four techniques of Capital Budgeting: before concluding why there is a difference in recommending these four techniques

1. Benefits & Discrepancies in NPV Technique:

Benefits:

• It considers Time Value Money Concept.
• Considers entire cash flow stream during the life of the project.
• It is based on cash flow than accounting profits
• NPV can use different rate of cost of capital for different time period and projects hence objectivity in analysis

Limitations:

• Requires predetermined rate of cost of capital
• Involves lengthy calculations
• Ignores initials size of investment

2. Benefits & Discrepancies in IRR Technique:

Benefits:

• It considers Time Value Money Concept.
• Considers entire cash flow stream during the life of the project.
• It is based on cash flow than accounting profits
• IRR can use different rate of cost of capital for different time period and projects hence objectivity in analysis
• IRR recommends those projects which would have higher returns than internal cost of capital thus helps maximizing shareholders wealth

Limitations:

• Involves tedious calculations
• assumes reinvesting future cash flows at a rate equals to IRR

3. Benefits & Discrepancies in PI Technique:

The benefits and limitation of PI are very much close to that of NPV

4. Benefits & Discrepancies in Payback Period Technique:

Benefits:

• A very simple concept to use and understand
• Facilitates selection of less risky project

Limitations:

• Ignores cash flow post payback period
• Does not consider Time Value Money Concept

Conclusion: After discussing merits and demerits of all the four capital budgeting techniques, we can say that there are discrepancies and differences in recommendations of the four techniques because of the following reasons:

• Use of cash flows in payback period vs. discounted cash flows in other three
• Use of one rate for cost of capital vs. multiple rates for cost of capital
• consideration of different size of initial investment in IRR and ignoring the same in NPV
• Difference in ranking under NPV and IRR for different size of investments.
• Consider whole amount of cash flows in NPC, IRR and PI and ignoring post payback period cash flows in Payback period method.
• Ease of calculations in Payback, NPV and PI but difficulty in IRR

Thus, we can say that both NPV and IRR would give same accept-reject conclusions but the ranking would be different under both the technique. PI is just a different way of expressing conclusion than NPV. payback period concept could be used just to make an initial analysis followed by either NPV or IRR techniques based on the situation either we are working on mutual exclusive proposal or independent proposals.