Question

GCC uses the following criteria to make capital investment decisions:

Effect on earnings per share (must be positive)

Payback period (must be less than six years)

Internal rate of return (must be less than 12 percent)

Net present value (must be positive at a 12 percent discount rate)

1.1. What are the advantages and disadvantages of each of these measures? (5)

1.2. Why do you think GCC uses all of these measures rather than just one of them? (5)

Answer 1

EPS its the profit obtained by the company after tax but before the dividend preference share to the waighted averege number of outstanding ordinary shares during the period and its very usefull in measuring company performance and profitability in future.

advantages

EPS is very easly to compute its value and comparing with the privious period in performance

EPS its help in measuring performance of the company by bringing the sign indicators of company to continues with business

EPS it considering the time factor by taking the current time in measuring performance in relation to the extracted data

Disadvantages

Eps its difficult to obtain the exalt numbers of ordinary shars outstanding during the period.

EPS refers to previous information on making decision of performance of the organization in future where its seems that its not bring realistic due to the economic factors change

Advantages and disadvantages of payback method:

Some advantages and disadvantages of payback method are given below:

Advantages:

1. An investment project with a short payback period promises the quick inflow of cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the business quickly. The payback period is important for the firms for which liquidity is very important.
3. An investment with short payback period makes the funds available soon to invest in another project.
4. A short payback period reduces the risk of loss caused by changing economic conditions and other unavoidable reasons.
5. Payback period is very easy to compute.

Disadvantages:

1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback period

While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages.

Advantages:

• With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
• With the IRR method, the advantage is that it shows the return on the original money invested.

Disadvantages:

• With the NPV method, the disadvantage is that the project size is not measured.
• With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.

The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).

This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.

Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.

While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.