Question

Capital budgeting represents one of the most important areas of Financial management. In essence, the entire future of the company is on the line. If projects are undertaken that do not yield adequate rates of return, it will have serious long-term consequences on the firm’s profitability and even on its viability.

As a financial analyst, which one of these techniques: NPV, IRR, or the Payback period, would you use to evaluate and rank competing projects? Explain why.

Answer 1

NPV is used to evaluate and rank competing projects. It is better than IRR and payback period.
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 of IRR
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 more than one negative cash flows occur in the project

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