(b) (i) Payback period
The payback period is the time taken for the cash inflows from a project to equal the cash
outflows. A maximum payback period may be set and if the project's payback period exceeds
this then it is not acceptable.
Advantages
(1) It is easily understood.
(2) It focuses on early cash flows, thereby indicating projects likely to improve liquidity
positions.
(3) It is claimed that the payback method reduces risk by ignoring longer-term cash flows
occurring further into the future which may be subject to higher risk.
Disadvantages
(1) It ignores the timing of cash flows within the payback period, the cash flows after the
end of the payback period (which may sometimes be considerable) and therefore the
total project return.
(2) It ignores the time value of money.
(3) It is unable to distinguish between projects with the same payback period.
(4) The choice of the payback period is arbitrary.
(5) It may lead to excessive investment in short-term projects.
(6) It takes no account of the variability of cash flows.
(7) It does not distinguish between investments of different sizes.
(ii) Net present value (NPV)
This method takes account of the timing of cash flows and the time value of the money
invested in the project. Future cash flows are discounted back to their present values. These
present values are then summed to derive the net present value of the project. If the result is
positive then the project is acceptable. If two or more projects are being compared then the
project with the highest NPV should be chosen.
The major difficulty in calculating the NPV is in determining the most appropriate discount
rate to use.
The main problem with the use of NPV in this situation relates to the difficulty of explaining it
to a (possibly) non-financial manager.
The NPV is preferable to the payback period, however, since it quantifies the effect of the
timing of cash flows and it takes account of the different magnitudes of investments when
comparing more than one investment.
(iii) Internal rate of return
The internal rate of return (IRR) is the discount rate which produces a zero net present value
when it is applied to the project's cash flows. If the IRR exceeds the investor's cost of capital
then the project is acceptable.
The IRR has the advantage of being more easily understood than the NPV and it does take
account of the time value of money.
Disadvantages
(1) The IRR may be confused with the accounting return on capital employed.
(2) It ignores the relative size of investments.
(3) When cash flow patterns are non-conventional there may be several IRRs. The cash
flows for the low investment option are non-conventional because of the need for
further capital investment after five years.
(4) The IRR is inferior to the NPV for ranking mutually exclusive projects in order of
preference.
(5) The IRR assumes that cash flows from the project can be reinvested to earn a return
equal to the IRR of the original project. |
