Question

Even though NPV, breakeven analysis, Schiller’s P/E, shut down can be to make decisions, why are they not used? What are limitations of these techniques? (reply in 400 words)

Answer 1

Limitations of NPV

NPV computation is done by summing the multiple discounted cash flows over the period of the investment. This makes NPV sensitive to discount rates. Therefore firstly, determination of accurate discount rate is difficult, and secondly even a small change in discount rate would make large changes in NPV. Discount rate in itself would depend on many factors such as business environment of the economy, stable government and so on.

Limitations of break even analysis

Breakeven analysis tries to determine minimum sales/profit in order to just avoid the losses. But it makes too many assumptions in calculating it such as favorable and stable external environment, no discounting of cash flows and so on. This makes the analysis over simplified and less practical.

Limitations of Schiller’s P/E

Schiller’s P/E of S&P500(or any other index) is calculated by dividing the current EPS of the index by the average of the CPI inflation adjusted earnings of past 10 years. Inflation adjustment though normalizes earnings due to inflation, the Schiller’s ratio still neglect a number of other reasons for increase (or decrease) in earnings such as change in interest rates, productivity growths, population growth etc. Moreover many a time the ratio fails in signaling the market ups and downs. Also usage of last 10 years data does not guarantee a correct prediction of future years anyways.

Limitations of Shutdown

The shutdown point is the point where the total revenue of a firm equals its variable costs. Any further loss in revenue from here would force the firm to shut down in the short run. We see that it ignores the fixed costs (note that break even analysis did not ignore the fixed costs). So a shut down analysis will give bad results for a firm having large fixed costs as owing to large fixed costs the firm would still not be able to recover its investments.

Another limitation is that that the analysis is strictly a short run function and may ignore favorable/unfavorable external environment which may come at play in the long run.