Question

Which of the following is considered the best method for financial managers when deciding project approval/rejection?

Select one:

A. Payback method

B. Discounted payback

C. NPV

D. IRR

E. MIRR

Answer 1

Answer: (c) NPV

Payback period is the length of time required to recover the cost of an investment. Knowing the amount of time that a project would take to recover the initial investment is essential to decide whether the project should be invested in or not. Shorter payback periods are preferred compared to longer ones. Payback period does not use discounted cash flows, thus is less accurate.

Discounted payback period is the length of time required to recover the cost of an investment after considering the time value of money.

Both Payback Period and Discounted Payback Period methods ignores the cash flows made after the payback period. Thus, two projects having same payback period/ discounted payback period seems indifferent though they are having different amount of cash inflows in later periods. Hence, they are considered less accurate for evaluating the project.

IRR assumes that cashflows are reinvested at same rate, which may not be possible. IRR method does not consider factors like project duration, future costs, or the size of a project i.e., project scale. The IRR simply compares the project's cash flow to the project's existing costs, excluding these factors.

MIRR assumes project cash inflows are reinvested at Cost of Capital but The main disadvantage of the MIRR method is the potential conflict with the NPV method. The reason is due to a difference in project scale or in the timing of cash flows are not considered.

NPV is a better method for evaluating mutually exclusive projects than the IRR or Modified IRR methods. The NPV method employs more realistic reinvestment rate assumptions, is a better indicator of profitability and shareholder wealth, and mathematically will return the correct accept-or-reject decision regardless of whether the project experiences non-normal cash flows or if differences in project size or timing of cash flows exist.

Hence, NPV is the best method for financial managers when deciding project approval/rejection.