Question

We discussed a number of criteria management can use to evaluate the suitability of projects before concluding that among NPV analysis, IRR analysis, Payback Period analysis, and Profitability Index analysis, NPV analysis is best. Discuss the purposes of the other 3 types, indicating what they can be used for, as well as where their shortcoming(s) enter into evaluations.

Answer 1

Internal rate of return (IRR):

Internal rate of return is a variation of NPV method. It gives the cost of capital at which present value of cash inflows is equal to present value of cash outflows. In other words, IRR derives the discount rate used in discounting of cash inflows and outflows.

Shortcomings:

· It assumes all cash inflows are reinvested at IRR rate which is not practical

· It does not give absolute npv of a project

· It ignores the project duration

· This method does not help in ranking projects on unequal size

Payback period:

Payback period is the method of capital budgeting which gives the payback period of initial investment based on cash inflows over the project duration

Shortcomings:

· It ignores the time value of money

· It ignores the cash flows after payback period

· It is not useful when there are cash outflows over multiple periods

Profitablity index:

Profitablity index is the method of capital budgeting which expresses present value of cash inflows as relative percentage of initial investment. It the ratio of present value of cash inflows to initial investment

Shortcomings:

· It ignores the absolute value of net present value

· It considers only actual cash flows and ignores opportunity cost