Question

Capital budgeting takes into account computing a projects payback, net present value, internal rate of return and return on investments. Discuss the advantages and disadvantages on using each of these.

Answer 1

Payback Period

Payback period is the period in which intial investment gets recovered. It calculates the years in which cost of project recovered by generating cash inflows in future. Least the Payback period more acceptable is the project.

Advantages

1. It is simple to calculate.

2. It measures the certainity of the project.

3. It helps in ranking the project which recover money early.

Disadvantages

1. It doesn't consider the time value of money

2. It doesn't consider the cash inflows after the payback period.

Net Present Value

Net Present Value is the difference between present value of cash inflows and persent value of cash outflows.

Advantages

1. It takes into consideration the concept of Time value of money.

2. It helps in analysing whether project is beneficial or not. If NPV is positive it means project will earn profit but if it is negative then project will generate loss.

3. It considers the cost of capital and risk entitled with the project to make projections about the future.

Disadvantages

1. It assumes cost of capital. If assumptions are not accurate then it can hinder the valuations.

2. It is not useful for the projects having different size. So one cannot compare such projects.

Internal Rate of Return

IRR is that discount rate at which NPV will be zero.

Advantages

1. It considers Time value of money

2. It considers all cash flows of the project whether early or later.

3. If IRR is higher then its cut of rate, results in maximum profitabilty to shareholders.

4. no assumption requires regarding cost of capital

Disadvantages

1. It is difficult to calculate and sometimes lengthy

2. It does not compare two mutually exclusive investments.

Return on investment

It measures a ratio of net income to cost of investment.

Advantages

1. It calculates relation of net income to investments, therefore, a good measure of profitability.

2. It helps in comparing different units in terms of profitability.

3. It is acceptable in accounting as well.

Disadvantages

1. It is hard to find perfect relation between profit and investment due to different concepts in defining profit and investment. Like profit can be profit before interest and tax, profit after interest and tax, investment can be on book value, market value.

2. If two companies follow different accounting principles then ROI cannot be useful parameter for comparision.

3. ROI focuses on short term profitability instead of long term profitability.