Question

What is the problem than can occur when using the NPV and IRR to evaluate mutually exclusive projects.  

What are the problems associated with using the payback statistic to evaluate capital budgeting projects?  

Describe the problems associated with using the IRR statistic to evaluate capital budgeting projects.

Answer 1

Since, multiple questions have been posted and each question is independent of another, I have answered the first two.

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Question 1:

The basic problem that can occur when using the NPV and IRR to evaluate mutually exclusive projects is the conflict that may arise as a result of different projects getting ranked differently by these two capital budgeting techniques. For Instance, while NPV may suggest Project A for acceptance (because of higher NPV than other projects), IRR may indicate Project B for further pursuance (because of higher IRR than other projects). Such a situation may arise when there is a difference in the pattern of cash flows provided by different projects or when there is a difference in the size/magnitude of the projects/investments under consideration. In both the scenarios, however, it is generally preferable to select the project which provides the highest NPV.

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Question 2:

Payback period is the time frame within which the initial investement is recovered by the company with the use of cash inflows provided by the project. The problems associated with using the payback statistic to evaluate capital budgeting projects are highlighted below:

1) One of the major limitations of the payback method of capital budgeting is that it ignores the time of value. In other words, the cash flows occurring in the future are not discounted to today's value while evaluating the project.

2) Second problem with the payback method is that it doesn't take into account the cash flows that occur after the initial investment has been recovered by the company. In other words, the cash flows occuring after the payback period are completely ignored by this method.