Question

Briefly identify, in bullet point form, the strengths and weakness of each method: Payback period, ARR, NPV, IRR.
Then explain which method for evaluating capital project proposals do you favor the most, and why?

Answer 1

1. NPV: (Net Present Value)

Advantages:

a. The most important advantage of NPV (net present value) is that it takes time value of money into consideration, i.e., it uses discounted cash flows.

b. It helps the management in the decision-making process. If NPV of a project is positive it is a good sign and similarly if it is negative that project is generally not undertaken by the company.

Disadvantages:

a. Biggest disadvantage is that since NPV is in terms of an absolute figure, it cannot be used to compare projects of different sizes.

b. Since NPV is calculated by calculating the net present value from "cash inflows" and subtracting the net present value of "cash outflows" there might be certain costs which will be left out such as sunk costs.

2. Payback Period:

Advantages:

a. The most important advantage is that it helps the management to determine the number of years it will take to recover their investment made on a certain capital asset or project.

b. It is comparatively much easier to understand and evaluate as compared to other methods.

Disadvantages:

a. The biggest disadvantage is that it does not consider time value of money.

b. Since it only estimates the time by which the initial investment is recovered, it only considers cash flow upto that time and does not consider the cash flows earned after the initial investment has been recovered.

3. IRR (Internal rate of return):

Advantages:

a. It is simple to use and easy to understand. it basically calculates the rate of return at which NPV will be zero.

b. It takes time value of money into consideration.

Disadvantages:

a. Major disadvantage of using IRR is that it ignores the reinvestment rates which can completely change the outcome and should be factored in.

b. It ignores the size of the project and it may make a small project which will generate lower profits look more attractive than a large project generating higher profits.

4. ARR (Average rate of return):

Advantages:

a. One of its major advantages is considered to be its simplicity. It is extremely easy to calculate and is preferrable for small businesses.

b. It is one of the few methods which take accounting profits into consideration.

Disadvantages:

a. Most major disadvantage is that it ignores time value of money.

b. Considering accounting profits instead of cash flows can be counter productive some times if some one time and major adjustments have been made in the books of accounts leading to an extraordinary accounting profit/loss.

I will favour NPV method for evaluating capital project proposals. This is because first of all it takes time value of money into consideration which is very important. Secondly it is calculated on the basis of cash flows which helps in showing the real profitability of thje project. Thirdly it also considers the reinvestment rate.