Question

Foundations of Financial Management Stanley Block 16

advantages and disadvantages of Payback, NPV, IRR of capital budgeting method

Answer 1

Of the three methods of Capital Budgeting listed in the question, the NPV method is the most comprehensive from a decision making perspective, but each of the methods has its own set of advantages and disadvantages which are listed below.

Payback Period method - The Payback period method is the most simplistic way to estimate the worth of a project on a comparative basis as it is used to estimate the number of years it takes to breakeven on the initial investment without factoring in for the time value of the future cashflows.

Advantages:

1. Since the initial investment is simply divided by a fixed series of cashflows in order to estimate the period it takes to payback initial investment, this is the simplest method for comparing two projects.

2. Rather than accounting for the profitability, this method is more relevant for estimating and factoring in the liquidity of the project, as the shorter it takes to return the initial investment, the more liquid is your investment (other methods fail to quantify the liquidity aspect)

Disdvantages:

1. Since the method doesn't account for time-value of future cashflows, it can't give a true value of the project as the money received tomorrow is not equal to the money received today.

2. The method doesn't help estimate the profitability of the project because it tends to ignore the cashflows beyond the payback period and thus can't be used for profit calculation.

NPV method - The NPV method is the most comprehensive way to estimate the worth of a project on a comparative basis as it is used to estimate the present value of a project after not just factoring in the initial investment and future cashflows, but also accounting for the time value of the future cashflows.

Advantages:

1. Given that the NPV method is the most comprehensive method of evaluating the worth of a project as described above, it can be used for practical decision making if one knows their cost of capital and future cashflows with reasonable degree of precision and hence can be used to compare between two totally different projects, on the basis of present net value of the two.

2. Since the method deals with the profitability of a project while factoring in ones cost of capital, it can be used on a standalone basis as well to estimate if the project yields a net positive cashflow for the given cost of implementing it.

3. Unlike the payback method, it accounts for all the estimated cashflows throughout the life of the project in order to arrive at its worth.

Disdvantages:

1. While the method accounts for time-value of future cashflows, the method in itself becomes complex for estimating the value in case of a long stream of cashflows or widely varying year-on-year cashflow values.

2. Since the method is primarily dependent on cashflows and cost of capital, errors in forecasting cashflows or wrong estimates of cost of capital can yield incorrect results for decision making purpose.\

IRR method - The IRR method estimates the internal rate of return which basically is the discounting rate which leads to an NPV of Zero. The same may be interpreted as the maximum rate of your cost of capital, beyond which the NPV of the project will become negative.

Advantages:

1. Similar to the NPV method the IRR method factors in the time value of money and the output of this method is a percentage rate as described above, which can be easily compared across different types of projects.

2. Since the method itself yields a rate of return, it doesn't require the input of cost of capital (like in the case of NPV) and hence can be used just on the basis of future cashflows and present investment amount.

Disdvantages:

1. The IRR method basically assumes that the intermittent cash inflows can be reinvested at the IRR till the end of the project tenure, which may not be the real case and hence may yield an incorrect result while making a accept/reject decision.

2. If the project involves certain cash outflows at a later stage, then the calculation might even result in multiple IRR values which satisfy the equation and hence the method loses its practical significance in such instances.

3. Unlike the NPV method, wherein two or more projects can be compared based on the NPV value in $ terms, IRR fails to provide effective comparison just on the basis of IRR in % terms, from a decision making perspective.