Question

1. Briefly describe the four following methods for evaluating a long-term project:
   • Payback Period
   • Net Present Value (NPV)
   • Internal Rate of Return (IRR)
   • Profitability Index (PI)
     
2. Why might a manager choose to evaluate a potential investment using Net Present Value (NPV) rather than Payback Period? What are a few weaknesses of Payback Period?

Answer 1

Payback period:-​​​​​​ Payback period method is method of capital budgeting to evaluate the Investment project . Under method,we take decision on behalf of payback period. Payback period is number of years in which the initial investment recovered by the future cash inflows. Less Payback period show low risk in comparison of other and that prioritize.

Payback period= initial investment/ Average annual cash inflows

Net present value method:- Under this method , Investment decision taken by calculating net present value. Net present value is difference between present value of future annual cash inflows and initial investment. Investment project have higher net present value prioritize.

Internal rate of return:- The Internal rate of return method is method of evaluating the Investment projects on behalf of Internal rate of return. Internal rate is discounting rate on which Net present of project equals to zero. In other words, difference of present value of future cash flows equal to initial investment

IRR = cashflow/ ( 1+ i) ⁿ - initial Investment

Profitability Index:- Under this method ,we takes decisions on behalf of profitability Index. Profitability Index is ratio of Present Value of future annual cash inflows and Initial Investment.

Profitability Index= Present Value of future Annual cash inflows/ Initial Investment

To potential evaluation of project ,NPV method prioritize because this method adjust time value of money . On other hand Payback method ignores Time value of money

Payback period doesn't covered all cash inflows

Payback period ignore discounting rate of Investment.