Question

Discuss the four alternative methods for evaluating capital budgeting projects? Explain the advantages and disadvantages of each method?

Answer 1

Solution : The various alternative methods of capital budgeting are enumerated below:

1. Payback period method

2. Net present value method

3. Profitability index method

4. Internal rate of return method

1. Payback period method : It is the time taken for the cash flow of incomes for a particular prject equal to the initial investment.

Advantages and disadvantages of payback period

Advantages	Disadvantages
· Simple and easy to understand	· Do not consider all the cash flows
· Useful in case of uncertainty	· Ignores time value of money
· High preference to liquidity	· Ignores and neglects return on investment

2. Net present value method : It is defined as the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Advantages and disadvantages of Net present value method:

Advantages	Disadvantages
· NPV gives importance to time value of money	· It is difficult to calculate the appropriate discounting rate
· Profitability and risks of projects are given higher priority	· It may not reflect the correct decision when the projects are of unequal life.
· NPV helps in maximizing the value of firm	· NPV is quite cumbersome to use

3. Profitability index: This method measure the ratio between the present value of future cash flows and the initial investment. It is a useful tool for ranking investment projects.

Advantages and disadvantages of profitability index :

Advantages	Disadvantages
· Considers the time value of money	· Difficult to understand the interest or discounting rate to determine the profitability index of a project.
· It is considered as widely used technique to evaluate different investment proposals.	· It is difficult to compare the projects having different estimated working life.
· Simple and easy to find out the suitable investment project based in profitability indexes.	· Not useful in decision making when the projects are mutually exclusive capital projects.
· It ascertains the accurate of return of project and takes risk factor into consideration.
· Helps in maximizing the value of firm

4. Internal rate of return method: The internal rate of return is the discounting rate at which the net present value of an investment is equal to zero.

Advantages and disadvantages of internal rate of return method:

Advantages	Disadvantages
· Considers the time value of money even the cash flows are even or uneven	· This method assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project. If the average rate of return earned by the firm is not close to the internal rate of return, the profitability of the project is not justifiable.
· Predetermining cost of capital is very difficult however this method helps to overcome the problem	· It involves complex calculations
· Profitability of project is considered over the entire economic life of project.	· Gives importance to profitability only and do not consider the recouping of capital expenditure.
· Its provides in maximizing profitability and maximizing shareholders wealth .	· The results ascertained under this method differ in their size , life and timing of their cash flows.

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