Question

Explain the relative advantages and disadvantages of the payback, net present value, and internal rate of return methods for evaluating capital budgeting projects. Which is the “best” method in your estimation and why?

Answer 1

Payback Method:

Advantages:

• It is simple to use
• Easiest way to compare projects.

Disadvantages:

• Does not consider time value of money
• Does not consider cash flows after payback period
• Ignores project profitability.

Net Present Value:

Advantages:

• Considers the time value of money
• Tells whether it will add value to shareholders wealth or not
• Considers the cost of capital and risk inherent in the project.

Disadvantages:

• Guessing of cost of capital might not be accurate and give vague results.
• Does not consider the size of the project.

Internal Rate of Return:

Advantages:

• Considers time value of money
• It is easy to interpret.
• Risk of determination of wrong hurdle rate is eliminated.

Disadvantages:

• Does not consider the project duration.
• Does not considers the future cost.
• Does not consider the size of the project.

Net Present Value method is the best method in estimation as Net Present Value uses a reinvestment rate that in which net proceeds will be reinvested which is a more realistic and better indicator of profitability and shareholder wealth. It also considers the future risk inherent in the project.