In: Finance
Pitfalls of each of the criteria for accepting/rejecting a project
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
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
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.