Question

Explain how payback period, NPV, and IRR criteria are used in decision making and
provide example in which each is most appropriate as an appraisal tool.

Table 1: Bank of Ghana Bill rates Issue Date 20 April 2020 27 Apr 2020 27 Apr 2020 Security type 91 day 182 day 91 day Discount rate 13.39 13.11 13.55 Interest rate 13.86 14.03 14.03

Answer 1

1. Payback period is a period in which the amount of cash outflow at the beginning is equated with cash inflows.

if there is smaller payback period, it will mean that the business is able to generate the cash inflows quickly and it is able to to enter into a break even very quickly so it would be beneficial project.

So smaller payback period will always be preferred and larger payback period will always be avoided

2. Net present value is a decision making tool in capital budgeting in which the value of cash inflows and cash outflows are discounted at the present using a discount rate to find net present value.

when there is positive value for net present value then project is to be accepted and when there is a negative value for net present value then the project is rejected

3.internal rate of return is the rate at which the discounted cash inflows are equated with the cash outflows in the beginning.

if the internal rate of return is higher than weighted average cost of capital or hurdle rate when the project is to be accepted, if the weighted average cost of capital of hurdle rate is higher than internal rate of return project is not to be accepted.

Payback period is used when there is regular payment and there are no irregular cash flows.

net present value is best in all three method and they can be used even if there are irregular cash inflows.

Internal rate of return is used when there is regular cash flows and multiple rate of return can be adjusted.