Question

Why must corporate managers use multiple techniques for project evaluation? Which technique is most commonly used and why? Describe several ways you may be able to use the techniques below as you progress in your professional career as a Financial Officer.

1. Payback Rule

2. Discounted Payback Period

3. Net Present Value

4. Internal Rate of Return

Answer 1

ans ) to assist the organization in selecting the best investment there are various techniques available on the comparison of cash inflows and outflows :

1 ) Payback period : payback period is the time required to recover the initial cost of an investment .it is the number of year it would take to get back the initial investment made for a project .

Features of payback period

• Easy to calculate
• Ignores the time value of money
• used in combination with other techniques of capital budgeting.

Limitations of pay back period :

• Ignores time value of money .
• Ignores after payback period profit

Formula of pay back period :

=  Investment / constant annual cash inflows

Formula is used when inflows are same.but when inflow are uneven :

PB = F + B / CFc

F = number of year immediately preceding the years of recovery .

B = balance of investment to be recovered .

CFc = cash inflows during the year of final recovery.

2 ) Discounted pay back period : A discounted pay back period gives the number of year it takes to break even from undertaking the initial expenditure ,by discounted future cash flow and recognize the TIME VALUE of MONEY.

Formula :

Discounted cash flow =

Actual cash inflow / ( 1 + I ) n

i = interest rate

n = period to which cash inflow related

Decision rules : shorter discounted payback period indicated lower risk , investment having similar return the one with shorter payback period should be chosen.

advantages : it account time value of money

Disadvantages : ignores cash inflows from project after payback period.

3 ) Net present value : is the difference between the present value of inflows and present value of outflow .

= PV of inflows - PV of outflow

PV of inflows = cash inflow × PVF

PVFn = 1 / ( 1 + r ) n

Advantages of NPV : Consider time value of money. 2 ) consider after payback period.3 ) wacc is most commonly used as hurdles rate.

Limitations of NPV : 1 ) in unequal initial investment projects it doesn't give satisfactory answer.

2 ) in case of different lives of projects it not give satisfactory results.

3 ) in case of independent project NPV method is nott good.

4 ) Internal rate of return : IRR is the discount rate at which the PV of inflows is equal to present value of cash outflow.

Assumption : all inflow are reinvested at Internal rate ( IRR ) not on wacc ( weighted average cost of capital )

Advantage : allow comparison of projects with differential initial outlays. Which NPV not allowed.

Calculation based on trial and error method.

Conclusion

In case of

Time disparity = NPV method is best

Size disparity = NPV method is best

Capital rationing = Profitability index techniques is best .

​​​​​In all the above discussion one can conclude that NPV is the best method because :

1. It considered time value of money
2. Consider after pay back period
3. Give satisfactory results in case of time and size disparities.
4. Use reality based assumption regarding reinvestment .

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