Question

Explain the project assessment methods that AMAZON company have used to assess capital projects completed in the last 5 -10 years (IRR, NPV, payback, and ARR). What are the advantages and drawbacks to using each one?

Answer 1

The various project assessment methods that firms use are the IRR, NPV, Payback method and the ARR.

IRR

Internal Rate of return is the rate at which the NPV of the project becomes equal to zero. If IRR is sued as a criterion then projects with an IRR greater than the cost of capital are accepted. The IRR of projects is used to rank them.The advantages of IRR method is that it, provides a measure of rate of return considers the time value of money and it does not require a cost of capital to compute. The disadvantages are it cannot be used when it comes to mutually exclusive projects since the reinvestment rate it assumes is unrealistic, the IRR method can sometimes provide multiple IRR.

NPV

The Net Present value of a project is the initial investment deducted from the sum of present value of cash flows. When the NPV method is used projects are accepted if the NPV is positive and are rejected if NPV is negative. The advantages of the NPV method are that it has a realistic reinvestment assumption(that cash flows are reinvested at cost of capital) , it provides a measure of profitability of the project being considered, it takes into consideration the time value of money, its simple to calculate and is reliable when it comes to mutually exclusive projects. The disadvantages are the NPV is based on estimated future cash flows which may vary, it cannot be used if the projects under consideration vary in size.

Payback

The payback method helps identify the time required to recover the initial investment on a project .The advantages of payback method are :its provides a measure of liquidity, its easy to calculate and understand .The disadvantages of payback period are :it ignores the time value of money , ignores the cash flows after the payback period and it always favours projects with longer lifetime.

ARR

The Accounting rate of return method calculates the return generated by a project as a percentage of its initial investment .the Accounting rate of return =Average Profit/initial investment. The advantages of this method are :its simple to calculate and easy to understand, provides a measure of the profitability of the project . The disadvantages are that it does not take into consideration the time value of money, the duration (life of the project ) is not considered, and it uses earnings instead of cash flows.