Question

Discuss the three decision tools used to analyze capital budgeting projects. What are the advantages and disadvantages of each tool?

Answer 1

Answer :

The most common decision tools used to analyze capital budgeting projects are :

1. Payback period :

Payback period is simply a calculation of how long it takes to get original investment back. It is a amount of time which it takes to recover the cost of investment.

Advantages :

• It's simple & easy to calculate.
• Assessment of investment risk.
• Useful in case of uncertainty.
• Helps manager for quick decision making.

Disadvantages :

• It ignores the time value of money.
• It ignores timing of cash inflows.
• Its useful for short term only.
• Not realistic in nature.
• Does not look at overall profit.

2. Net Present Value

NPV is the difference between present value of cash inflows and cash outflow over a period of time. It is use to analyze the profitability of capital budgeting projects.

Advantages :

• It considers the time value of money.
• Helps in decision making.
• It consider all cash inflows.
• It allows risk factors for considering calculation.

Disadvantages :

• It can't be used to compare with projects of different sizes.
• It does not consider any sunk cost or hidden cost for calculation.
• Difficult to determine required rate of return.
• Not helps in improving EPS or ROE.

3. Internal Rate of Return

Internal Rate of Return is a discount rate which makes net present value of all cash flows equal to zero. It is a simpler variation of net present value method.

Advantages :

• It helps in comparing several projects simultaneously.
• It considers the time value of money.
• Helps in decision making.
• It does not require hurdle rate or required rate of return.

Disadvantages :

• It is mainly based on assumption.
• It ignores size of project.
• It ignores future cost.
• Not helpful for comparing two mutually exclusive projects.