Question

Discuss the following - make sure you discuss the strengths and weaknesses of each valuation method. Also discuss why many of these are used together and not necessarily independently to make decisions.

• Net present value
• Internal rate of return
• Payback
• Discounted payback
• Profitability index

Answer 1

1.Net Present Value(NPV)

NPV is technique used in the capital budgeting to analyze or determine the profitability or viablity of project or investment.It is the difference between the

a)Present value of cash inflows and

b)the present value of cash inflows

that occurs from the investment or project.

The advantages of NPV technique includes:

a)It consider time value of money.

b)helps the management of the company in better decision making

The disadvantages of NPV technique includes:

a)It does not consider the hidden cost incuured in relation to particular project

b)It cannot be used for comapring different sizes project.

2.Internal rate of return(IRR)

It is used in capital budgeting to estiamate the profiatabilty of potential project/investment.It is the discounting rate at which total of initial cash outflows and discounted cash inflows are equal to zero.Alternatively,it is the rate at which NPV of a project/investment is zero.

The advantages of IRR  includes:

a)It consider time value of money.

b)In case of IRR,there is no need of pre determination of cost of capital.

The disadvantages of IRR includes:

a)It does not take into consider the duration of the project.For example,if project A has higher IRR and duration longer than the Project B,then if the company select project A because it has higher IRR than project B it would be incorrect as the duration of project A is longer.

b)IRR assumes that the cash flows are reinvested at the same rate as the project,instead of the cost of capital.Hence,it may not present true picture of profiatability.

3.Payback

Payback period can define as the length of the time required to recover the initial cash outlay in the project.

The advantages of Payback includes the following:

a)It is very easy to calculate and simple to understand.

b)Payback reduces or avoids the loss through obsolescence since shorter payback period is preferred over longer payback period.

The disadvantages of Payback includes the following:

a)It totally ignores the cash inflow after after the payback period.

b)this method overlook cost of capital:which is important consideration in making sound investment decision.

4.Discounted Payback

It is same as payback period with one difference that it take into account time value of money.To calculate it we need to add the discounted value of each future cash inflows as long as the initial outlay is recovered.

It has the same advantages and disadvantages as Payback.

5.Profitabilty Index  

It measure the ratio between the present value of future cash flows and the initial outlay.

Advantages of Profitabilty Index  

a)Profitabilty Index ascertain accurate rate of return of the project which is important to know the profitability of the project.

b)It is easy to caculate,so it is widely used technique to evaluates the projects.

Disadvantages of Profitabilty Index(PI)

a)It is difficult to estimate cost of capital and discount rate to detremine the PI of the project.

b)It is difficult to comapre the projects having different working life,using PI method.

Since all the above method has its limitations and benifits,thus it is not possible for the organisation to evaluate the investments decisions using particular method,hence it is always preferable to use two or more method together to arrive at the decision.