Question

You have been asked by the owner of your company to advise her on the process of purchasing some expensive long-term equipment for your company.

Give a discussion of the different methods she might use to make this capital investment decision. payback method, etc.

Explain each method and its strengths and weaknesses. Indicate which method you would prefer to use and why.

Answer 1

payback period it is method which is good method when considering the liquidity

payaback period is method which is ued to calculate the time required to return the amount invested  

strength	weakness
The concept is extremely simple to understand and calculate.	it does not consider the time value of money
The analysis is focused on how quickly money can be returned from an investment	Neglects cash flows received after payback period
Since this analysis favors projects that return money quickly, they tend to result in investments with a higher degree of short-term liquidity.	Ignores a project's profitability

Net present value (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit.

strength	weakness
NPV consider time value of money	only considering the cashflow and not considering other cost like opportunity cost
The NPV method produces a dollar amount that indicates how much value the project will create for the company	determination of interest rate is hard to discount
NPV method takes into consideration the cost of capital and the risk inherent in making projections about the future	determination of estimated future cashflow

Internal rate of return :The internal rate of return is a metric used in financial analysis to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

strength	weakness
consider time value of money	it is relative measures not absolute
easy and simple to understand	non-conventional cashflows gives multiple rates
calculate the rate of return on the investment and based on cashflows not accounting profit	it doesnot show how much value added to the company

net present value method is better method

it is more realistic as it assumes that cashinflows will reinvest for cost of capital rate but in IRR it is assumed that it will reinvest in IRR rate and Payback period doesnot consider timevalue of money