Question

Discuss the advantages and disadvantages of Net Present Value, Internal Rate of Return, & the Payback Method. Is one better than the others?

Answer 1

Net Present Value (NPV)
Advantages:
It considers time value of money.
Both the cash outflows (investment in a project) and inflows of an project are considered.
Importance is given to profitability and the risk associated with the projects.
Positive NPV helps in maximizing the shareholders' value and projects with higher NPV values are accepted.
Disadvantages:
Mutually exclusive projects are the set of projects out of which only one project should be considered. If the investment amount of two mutually exclusive projects are unequal, net present value method fails to give accurate decision. Also, following NPV decision rule for the projects with unequal lives might not be correct decision.
To calculate NPV we need discount rate and it is difficult to determine exact discount rate.

Internal Rate of Return (IRR)
Advantages
It considers time value of money, and the calculation of IRR is simple.
Using IRR managers rank the projects and then compare the IRR of the projects with the required rate of return and then consider the project with highest IRR.
In case of IRR, it is not needed to calculate the required rate of return. We determine the value of IRR by taking NPV=0 and then compare the IRR with the required rate of return. Project with highest IRR is accepted.
Disadvantages
It provides incomplete information regarding the change in shareholders' value.
Internal rate of return ignores the scope and size of an investment like whether an investment is huge or a small investment. It is only concerned about the internal rate of return of the investment.
Internal rate of return doesn't consider re-investments.
Highest importance is given to profitability.

Payback method:
Advantages:
It is an easy capital budgeting technique used for decision making and is also used universally.
Importance is given to liquidity as to how faster an investment will reach its break even point, and based on that decision is taken as to whether a firm should accept or reject a project.
It also deals with risk, investments with shortest payback period will have less risk and vice versa.
Disadvantages:
Time value of money is not considered in case of payback period method.
Payback period method ignores profitability and gives higher importance to liquidity.
Once the break even is achieved, cash flows after the payback period is not considered.

NPV is considered better than the others because it gives importance to profitability and helps in maximizing the shareholders' value.