Question

Three distinct capital budgeting tools are referred to including NPV, payback and IRR, but all three need to be used simultaneously as the advantages of one are disadvantages to the other.

What are the advantages and disadvantages of each of the capital budgeting tools?

Why would they all need to be used simultaneously?

Answer 1

.1.Net Present Value (NPV)

Advantages:

• It take into account time value of money
• Cost of capital and risks are considered in determining discount rate
• Cash flows are used instead of accounting income
• All relevant cash flows throughout project life are considered in NPV calculation
• It can handle cash flows with any number of change of signs

Disadvantages:

• Calculations are tedious
• There is an element of subjective discretion in deciding risk premium to arrive at appropriate discount rate
• Estimation of cash inflows and outflows are difficult

.2.Payback Period

Advantages:

• Simple to understand
• Simple to communicate
• Quick and simple calculation

Disadvantages:

• It ignores cost of capital
• It ignores risks
• It does not take into account time value of money
• Tendency to accept low risk projects
• Long term projects generating shareholders wealth in long term likely to be rejected
• Does not consider cash flow after payback period, even if it is high
• The payback cut off period is subjective

.3.Internal Rate of Return (IRR)

Advantages:

• Easy to understand and compare with the hurdle rate
• Simple to communicate
• It takes into account time value of money

Disadvantages:

• Calculation is complex and time consuming
• There will be multiple results if there is more than one change of sign

In Capital budgeting process number of projects need to be evaluated.

Payback period may be used as a first stage screening tool. Projects having less than required payback may be rejected at the outset.

IRR may be used as second stage screening tool. Project whose IRR does not meet the required hurdle rate may be rejected.

Finally, the projects passing through the two stage screening process may be taken upfor evaluation using NPV..

Since NPV indicates amount of wealth created for the shareholders, projects with high NPV and within budgeted costs should taken up for final selection