Question

Respond to the following in a minimum of 175 words:

Managers can choose from several analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages. Distinguish between the 3 capital investment techniques of (1) Net Present Value, (2) Internal Rate of Return, and (3) Payback Method.

Describe what you consider to be the top 2 advantages and 2 disadvantages of each technique and provide an example to support your top advantage of each method.

Answer 1

The Net Present Value(NPV) method can be used to evaluate the viability of a project.The NPV method deducts the present value of inflows from initial outflow.When the NPV method is used as the criteria to evaluate projects ,projects with positive NPV are accepted as they add value to the firm.Projects with negative NPV are rejected.the advantage of NPV method is that it returns a dollar value and is an absolute measure.Another advantage is that it assumes that the reinvestment occurs at the cost of capital which is realistic .The two disadvantages would be that the estimation of discount rate would be difficult.Another disadvantage is that it cannot be used when projects are of different sizes.Example of its major advantage:If the NPV of a project is $1000 it would mean that accepting the project would add a value of $1000 to the firm.This is an absolute measure and is a dollar return.The IRR(Internal rate of return) method returns the rate at which the NPV would be equal to zero.When IRR is used as the criteria ,projects with IRR lower than cost of capital are rejected.Projects with IRR greater than Cost of capital are accepted.The major advantage of IRR is that it's very clear and easy to understand if IRR is greater than cost of capital the project can be accepted.Another advantage is that it gives the return on money invested.A disadvantage of IRR is that it implicitly assumes that the cash flows are reinvested at IRR which is an unrealistic assumption.Another disadvantage is that it can give multiple IRR's when used to evaluate projects with positive cash flows followed by negative ones.Example:If you are given the cash flows associated with the project the IRR can easily be computed using excel function IRR().The value generated can be used to ascertain whether the project is worth pursuing after comparing it with cost of capital.The payback method helps to determine the time required to recover initial outflow.The biggest advantage of payback method is the ease in calculating payback period.Another advantage is that it provides a measure of liquidity.A disadvantage is that it ignores the time value of money.Another disadvantage would be that it ignores cash flow beyond the payback period.Eg:Assume we are given a project with initial outlay of $5,000 followed by $1000 each of inflows for 10 years.The Payback period can easily be estimated using the formula Initial Outflow/annual inflows we get it as $5000/$1000 that's 5 years.It does not require a discount rate, and is easy to understand