Question

-In your own words, discuss the pros and cons of the payback period, discounted payback period, internal rate of return, net present value, and profitability index.

-Which method is the best approach to evaluate a project and why?

-What is the relationship between IRR and NPV? Do they always result in the same decision? If yes then no further explanation needed and if no then under what circumstances do IRR and NPV results differ?

Answer 1

Simple payback period is the time required for complete recovery of the intial investment in the project. PBP(pay back period) pros are 1)simple to understand & easy to calculate. 2)very suitable method in case of industries where risk of technological obsolescence is very high,hence projects with shorter PBP should be opted for. 3)it clarifies the concept of profit because profits arises only after recovery of intial investment. 4)this method promotes liquidity by stressing on projects with earlier cash inflows and it is a very useful tool in case of liquidity crunch and high cost of capital. Cons of PBP 1)focuses on capital recovery rather than profitability .2)it ignores the time value of money cashflow occurring at all points of time are treated equally.this goes against basic principles of financial analysis,which stipulates compounding or discounting of cash flows when they arise at different points of time. Discounted payback period when payback period is computed after discounting the cash flows by a pre determined rate it is called discounted payback period. Pros of disc PBP 1)it considers the time value of money .2)it focuses on projects which generates cash inflows in earlier years,thereby eliminating risk of uncertainty. 3)incase of mutually exclusive projects the one with shorter PBP should be accepted. Cons 1)this method fails to determine whether the investment made will increase the firm's value or not. 2)calculation of discounted PBP is difficult if the project involves multiple negative cashflow during the investment period. 3)it does not consider post payback cash flows & hence not a good measure to evaluate where the comparison is between two projects where one involves long gestation period and other is yielding quick results but only for a short period. Net present value method (NPV) it is sum of present value of all future cash inflows less sum of present value of all cash outflows of the project. Pros 1)it considers time value of money. 2)unlike Payback period, all cash flows are considered including post payback returns. 3)NPV constitutes addition to the wealth of shareholders & this focuses on basic principle of financial management. 4)since all cash flows are converted into their present value,different projects can be compared on NPV basis thus, each project can be evaluated independent of others on it's own merit. cons of NPV 1)it involves complex calculations in discounting and present value computations .2)NPV & project ranking may differ at different discount rates,causing inconsistency in decision making. 3)it ignores the difference in intial outflows,size of different proposals etc.while evaluating mutually exclusive projects. internal rate of return (IRR) rate at which discounted cash inflows equal the discounted outflows. Pros of IRR 1)time value of money is considered 2)all cash inflows of the project arising at different points of time are considered. 3)decision are immediately taken by comparing IRR with firm cost of capital. 4)it focuses on maximization of shareholders wealth cons of IRR 1)it is only an apporximatoin & cannot be computed exactly always without use of computer and spreadsheet software. 2)it is very tedious to compute incase of multiple cash outflows,which sometimes result in multiple IRR creating difficulties for decision making. 3)the presumption that all future cash inflows of a proposal are reinvested at a rate equal to IRR practically may not be viable. profitability index (PI) Represents the amount obtained at the end of project life for every rupee invested in the project. Pros of PI 1)it is a better project evaluation technique than NPV and helps in ranking projects if npv is positive. 2) it focuses on maximizing return per rupee of investment, very useful incase of divisible projects where the funds are not fully available and needs to be prioritized. Cons of PI 1)it fails as a guide in resolving capital rationing problems,when projects are indivisible. Once a single large project with high NPV is selected possibility of accepting several small projects which together may have higher NPV than the single project is excluded. The relationship between IRR & NPV is that IRR is the discount rate at which NPV of the project equal to zero.and the higher the NPV The higher the IRR however IRR & NPV may give conflicting results in evaluation of different projects 1)if there is intial investment disparity different project size. 2) project life disparity. 3)cash flow disparity I.e., when there is a huge difference between intial CFAT & later years CFAT ,a project with heavy intial CFAT than compared to later years will have higher IRR, and vice versa. NPV is superior and must be preferred for decision making because it considers ko as a constant unlike IRR where discount rate is determined by reverse working by setting NPV=0 and it considers timing difference in cashflow at appropriate discount rate and also it does not poses interpretation problems if cash outflows arise at different points of time. And aids in decision making process.