Question

Identify one primary strength and one primary weakness for each of the following methods of investment analysis: A. Net present value B. Internal rate of return C. Payback

Answer 1

A. Net present value

The obvious strength of the net present value method is that it takes into account the basic idea that a future dollar is worth less than a dollar today. In every period, the cash flows are discounted by another period of capital cost.

Its primary weakness of the NPV method is that it is not useful for comparing two projects of different size. Because the NPV method results in an answer in dollars, the size of the net present value output is determined mostly by the size of the input.

B. Internal rate of return

The strength of IRR is that it considers the time value of money even though the annual cash inflow is even and uneven, which makes the ranking of project proposals is very easy under Internal Rate of Return since it indicates percentage return.

The primary weakness of this method is that it is assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project. If the average rate of return earned by the firm is not close to the internal rate of return, the profitability of the project is not justifiable.

C. Payback Period

The most significant strength of the payback method is its simplicity. It's an easy way to compare several projects and then to take the project that has the shortest payback time.

The most serious weakness of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years.