Question

Explain the following alternative decision tools to net present value in making investment decisions:

1. Book Rate of Return
2. The Payback Period
3. Internal Rate of Return
4. Profitability Index

Highlight any advantages or disadvantages of these alternative evaluation techniques in comparison to the use of net present value.

Answer 1

Book Rate of Return is ratio of book income to book assets.
Advantages: Easy to Calculate and understand.
Disadvantages:
1. It does not include time value of money.
2. It is not as compared to NPV in accepting or rejecting project.

Pay back Period is the period when the initial investment is recovered by future cash inflows.
Strengths of Payback Period
1. Easy to calculate and calculate and less time consuming
Weakness of Pay Back Period
1. IT doesn’t consider cash flows after Payback period.
2. It does not include time value of money

IRR is the discount rate at which NPV of Project Cash Flows is equal to 0.As per IRR rule, when IRR is greater than discount rate project should be accepted.
IRR:
Advantages:
1. Includes time value of money.
2. Good in accepting independent projects.

Disadvantages
1. Is not good for acceptability with large scale projects where it might be rejected when comparing with small scale project if IRR is higher.
2. IRR and NPV may conflict in certain case where NPV rule Prevails.
3. IRR rate is higher than WACC generally so reinvestment as higher than WACC may not be possible always.
4. It gives multiple IRR when more than one negative cash flows occur in the project.

PI index is ratio of PV of Cash flows to initial investment.If PI is greater than 1 Project Should be accepted.

PI :
Advantages:
1. It factors in time value of money.
2. It helps in choosing project when there is constraint in initial investment.
3. It accounts for the risk in the project.
Disadvantages:
1. It doesnot include sunk cost
2. It doesnot give information about the scale of the increase in value of the firm due to a project.
3. It doesnot help in choosing from projects with different lives.