Question

Pitfalls of each of the criteria for accepting/rejecting a project

Answer 1

Their are many metrics which can be used in capital budgeting to estimate the profitability of potential investments. Some of the popular one are :

1. NPV

2. IRR

3. PAYBACK PERIOD

4. MIRR, etc..

Now, let's understand their pitfalls one by one :

1. NPV

• The NPV method does not measure the project size.
• The IRR method can, at times, give you conflicting answers when compared to NPV for mutually exclusive projects.

2. IRR

The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime are negative (i.e. the project operates at a loss or the company needs to contribute more capital).

This is known as a "non-normal cash flow," and such cash flows will give multiple IRRs.

3. PAYBACK PERIOD

• Ignores Time Value of Money
• Not All Cash Flows Covered
• Not Realistic
• Ignores Profitability

4. MIRR : The disadvantage of MIRR is that it asks for two additional decisions i.e. determination of financing rate and cost of capital. These can be estimates again and the managers in real life may hesitate in involving these two additional estimates.