Question

Please define and explain the primary disadvantage or each of the following capital budgeting methods and the alternative methods which rectify that disadvantage: Payback Period; NPV; and IRR.

Answer 1

Payback Period Method:

Primary disadvantage:

This Method fails to take into consideration time value of money, e.g inflow of $1000 in year 1 would be treated same as inflow of $1000 in year 5 despite the pact that value of inflow in year 5 would be lower than the inflow in year 1 due to inflation.

Alternative method would be to use NPV method or IRR Method as they take into account the time value of money.

Net Present Value Method:

Disadvantage:

NPV Method is not useful in comparing the projects of different sizes. for example NPV for a $500,000 project would be always higher than a $1000 project due to larger size of input, even though a $1000 project may be giving hiher returns ob=n percentage basis.

Alternate Methodin this scenario can be IRR method because considers the returns from the project in order to recover the cost of the project.

Internal Rate of Return

Disadvantage:

In order to compute internal rate of return one must take into account number of external factors, which can be infact very difficult to predict.

This method involves projections such as to costs, market conditions and interest rates. Being conservative in these projections can result in missed investment opportunities whereas being to aggressive can result in highly optimistic IRR which may or may not materialize.

Now there is no alternative method as to which to use, infact all the methods can be used in conjuction with each other depending upon the problem at hand.