Question

Q#6) Calculate the payback period for the following: a) Project A: Initial Cost $80,000 earns $19,000 per year. Project B: Initial Cost $100,000 earns $25,000 per year and b) What are the downsides of using of using payback period to analyze a project? c) What could you consider as limitations of Net Present Value (NPV) and Internal Rate of Return (IRR) approaches in making capital investment decisions? d) What do you know about Profitability Index (PI), Modified Internal Rate of Return (MIRR) and how is MIRR different from IRR?

Answer 1

(a)

Project A ProjectB

Payback period 80,000/ 100,000/25,000

=.21 =4

(b)

Downside using  Payback period to analyze aproject

Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years.

(c)

Limitations of Net Present Value in Capital Investment decisions are:

• The biggest problem with using the NPV is that it requires guessing about future cash flows and estimating a company's cost of capital.
• The NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project.
• The NPV approach is difficult to apply when comparing projects that have different life spans.

Limitations of Internel Rate of Return in capital investment decisions are

• Economies of scale is ignored
• Impracticable implicit assumption of reinvestment rate at the IRR itself for remaining period of the project
• Dependent or Contingent project are being ignored while calculating IRR
• Mutually exclusive projects are ignored
• Different tems of project is not considered by IRR method
• Mix of positive and negative cash flows
• If later cash inflows are not sufficient to conver initial investment of calculation of IRR is not possible

(d)

  

The profitability index (PI), PI is referred to as value investment ratio (VIR) or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project.The profitability index (PI) is a measure of a project's or investment's attractiveness.The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.

The modified internal rate of return (MIRR) It assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost.MIRR improves on IRR by assuming that positive cash flows are reinvested at the firm's cost of capital.MIRR is used to rank investments or projects a firm or investor may undertake.MIRR is designed to generate one solution, eliminating the issue of multiple IRRs.

Difference between MIRR and IRR

ASIS FOR COMPARISON	IRR	MIRR
Meaning	IRR is a method of computing the rate of return considering internal factors, i.e. excluding cost of capital and inflation.	MIRR is a capital budgeting technique, that calculate rate of return using cost of capital and is used to rank various investments of equal size.
What is it?	It is the rate at which NPV is equal to zero.	It is the rate at which NPV of terminal inflows is equal to the outflow, i.e. investment.
Assumption	Project cash flows are reinvested at the project's own IRR.	Project cash flows are reinvested at the cost of capital.
Accuracy	Low	Comparatively high