Question

Explain the shortcomings of the IRR(internal rate of return )and PB(the payback). Which alternatives correct for these issues? Understanding the major issues with these why are they among the most popular for financial managers to reference?

Answer 1

   In capital budgeting, there are different approaches that can be used to evaluate a project. Each approach has its own advantages and disadvantages. Most executives use methods that look at a company's capital budgeting and performance expressed in percentages because it provides more and easy understanding and also allows comparability. In these cases, they tend to prefer using IRR or the internal rate of return instead of the NPV or net present value. BecauBecause it makes more understandable to the users.

The pay back period method is used to quickly evaluate the time it should take for an investor to get back the amount of money put into a project. Those investments with even cash flows are computed by dividing the cost of the investment by the annual net cash flow.

Now lets discuss about the drawbacks of this methods and in which circumstances this methods may fail.

A disadvantage of using the IRR method is that it does not consider the project size when comparing the projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. There is a big problem will arise when we simply compare the cashflows of the project. Because understanding the project size is very important in the comparison. Project size makes it more complex. So without considering the size we will not get the accurate data. The another draw back of IRR is it ignores the future cost going to occur. Here we only consider the previous cost and cashflow. Here also the reinvestment cost is not considered. These are the drawbacks of IRR methods.

When we considering the payback method the main disadvantage of this method is it will not consider the time value of money. Here the cashflow earned in earlier years is more considered and it will get more weightage than the cashflow earned in future years. Here profitability factor is completely ignored. Payback period is not considering the profitability.

These are the disadvantages with these methods which we used to find out our return or analysis of cashflow of a project.

Since there are many disadvantages these methods are most used and popular in the analysing. Why?

Because these 2 methods simplify the project and provide easy comparison of different projects. It is also very easy to calculate the cashflow by this methods. Despite of the accuracy the msimplifiedore simplified method is more preferable among the users.

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