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In: Accounting

Discuss the three decision tools used to analyze capital budgeting projects. What are the advantages and...

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

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Expert Solution

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.

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