Question

Discuss advantages and disadvantages of the following of the following capital budgeting techniques:

1.NPV

2.IRR

3.Payback

Initial response 250-300 words

Answer 1

Net Present value(NPV)

Net present value is the present value of a project's future cash flows less the initial investment in the project.It discounts all expected future cash inflows along with outflows to the present.An advantage of NPV is that it gives a dollar figure which acts as an indicator of the amount of value added by a project to the firm.This can also come in handy when evaluating a combination of projects .In such cases the NPVs of the projects under consideration can be added together to develop an understanding of the effects of accepting a possible combination of projects.Another advantage of using the NPV method is that it can be used for evaluating projects with required rate of return that varies over their life.The NPV method also considers the time value of money which can also be considered an advantage .A major disadvantage of NPV method is that it can cause a lot of difficulty when trying to compare projects with varying life spans.

IRR(Internal Rate of return)

The IRR method provides an estimated discount rate at which the PV of net cash inflows equal to the initial investment.The advantage of IRR is that it is simple to use as an evaluation criterion.If the IRR is higher than the cutoff rate(hurdle rate) the project is accepted else rejected.another advantage is that the IRR method also takes into consideration the time value of money ,the initial cash outflow and cash inflows after the initial investment.The major drawback with IRR is that it only returns a percentage figure and not the actual dollar value.Another disadvantage is that it cannot be used to evaluate a combination of projects since their IRRs that are expressed in percentages cannot be added together.Another drawback is that if the initial investment is not recovered by the future cash flows the IRR method cannot be used.IRR method assumed that all cash flows can be reinvested at IRR which is not realistic.

Payback Method

The payback method in capital budgeting determines the number of years that's required in order to recover the initial investment in a capital budgeting project.The payback method can be modified so as to include the discounted cash inflows .this is called the discounted payback method.The major advantage of payback method is that it uses a simple calculation.Another advantage is that the results it generate are easy to understand .Another advantage is that provides a rough measure of liquidity.It's major disadvantage is that it ignores the time value of money .It also ignores the cash flows that occur after the payback period.the payback method also fails to provide a measure of profitability.Another flaw with the method is that it promotes acceptance of short term projects if target payback period is too short.