Compare the results of the three methods (Payback Period, Net Present Value and Internal Rate of Return) by quality of information for decision making.
A Payback Period reflects the length of time to recover the payment of the investment. Investment rule according to this method is: accept the investment if its life is shorter than or equal to the cut-off period. It is calculated as: Payback Period = Cost of Project / Annual Cash Inflows. In case of mutually exclusive investment, the payback with the shortest life is to be accepted. The major disadvantage of this method is: early cash flows are taken into account and timing of cash flows is not considered and the method also ignores the risk factors as paybacks with different risk may …show more content…
The Net Present Value depicts the change in owner’s wealth if project is accepted. It is calculates as NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial Investment where R is the rate of return and T is the number of time periods. Investment rule according to this method is: Invest if Net Present Value > 0 or do not invest if Net Present Value < 0. The major disadvantage of this method is: The options which can be exercised during the useful life of the project are generally ignored. Thus it fails to take into account significant flexibility options which can be exercised during the life of the project.
Internal Rate of Return is the rate of return that makes the present value of the future after tax cash flows equal to investment outlay. It is one of the most commonly used method in capital budgeting. It is calculated as: NPV= ∑ {Period Cash Flow / (1+R)^T} - Initial Investment . The method is also used by security analyst. Investment rule according to this method is: Invest if Internal Rate of Return >Cost of Capital. The major disadvantage of this method is: The method assumes that cash inflows can be reinvested at the Internal Rate of
A Payback Period reflects the length of time to recover the payment of the investment. Investment rule according to this method is: accept the investment if its life is shorter than or equal to the cut-off period. It is calculated as: Payback Period = Cost of Project / Annual Cash Inflows. In case of mutually exclusive investment, the payback with the shortest life is to be accepted. The major disadvantage of this method is: early cash flows are taken into account and timing of cash flows is not considered and the method also ignores the risk factors as paybacks with different risk may …show more content…
The Net Present Value depicts the change in owner’s wealth if project is accepted. It is calculates as NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial Investment where R is the rate of return and T is the number of time periods. Investment rule according to this method is: Invest if Net Present Value > 0 or do not invest if Net Present Value < 0. The major disadvantage of this method is: The options which can be exercised during the useful life of the project are generally ignored. Thus it fails to take into account significant flexibility options which can be exercised during the life of the project.
Internal Rate of Return is the rate of return that makes the present value of the future after tax cash flows equal to investment outlay. It is one of the most commonly used method in capital budgeting. It is calculated as: NPV= ∑ {Period Cash Flow / (1+R)^T} - Initial Investment . The method is also used by security analyst. Investment rule according to this method is: Invest if Internal Rate of Return >Cost of Capital. The major disadvantage of this method is: The method assumes that cash inflows can be reinvested at the Internal Rate of