Question

Please define and explain the primary disadvantage of each of the following capital budgeting methods and the alternative methods which rectify that disadvantage:

            Payback Period; NPV; and IRR. (2 points)

Answer 1

Disadvantages of Payback

· Ignores the time value of money. Note: A discounted payback period may be calculated to overcome this problem

· Does not take into account cash flows beyond the payback period

· Assumes the cash flows occur at the same rate throughout the year

Disadvantages of NPV

· Fairly complex

· Not well understood by non-financial managers

· It may be difficult to determine the cost of capital

Disadvantages of IRR

· Difficult to calculate IRR and interpolation provides an estimation of the true IRR.

· It is a percentage return, not a measure of absolute profitability.