Question

Explain how the following techniques work, pointing out any shortcomings and advantages of each approach.

Payback Method
Net Present Value Method
Internal Rate of Return Method
Accounting Rate of Return Method

Answer 1

Payback Method

The payback method in capital budgeting determines the number of years needed to recoup the net initial investment in a capital budgeting project. In other words, the payback represents the break-even point in terms of cash flows for the investment

Net Present Value Method

NPV is the amount in dollars today that an investment is worth over its cost.

NPV may be interpreted in this way:

· An NPV of zero means that the investment earns the same rate of return as the required rate of return.

· A positive NPV indicates that the investment earns a higher rate of return than the required rate

· A negative NPV means that future cash flows will earns a return less than the required rate.

Internal Rate of Return Method

The internal rate of return (IRR) estimates the discount rate that makes the PV of net cash inflows equal to the initial investment. In another way IRR is a discount rate that will make the NPV of an investment zero.

Accounting Rate of Return Method

Accounting rate of return is the ratio of estimated accounting profit of a project to the average investment made in the project.

Methods	Advantages	Disadvantages
Payback Method	Uses a simple calculation	Ignores the time value of money
	Produces results that are easy to understand	Ignores cash flows occurring after the payback period
Net Present Value Method	Considers time value of money	Cannot be used to compare projects of different sizes
	Decision Making	Hidden cost
Internal Rate of Return Method	Time value of money is considered	Economies of scale is ignored
	Simple to interpret after the IRR is calculated	Mutually exclusive projects are ignored
Accounting Rate of Return Method	It is easy to compute and understand	it disregards the time factor in terms of time value of money
	Rate of return may readily be calculated with the help of accounting data.	Rate of return method considers only the rate of return and not the length of project