Business
Net present value is one of the most widely used financial methods for the investment appraisal. The first advantage of using the NPV method of investment appraisal is that it incorporates the time value of money. Moreover, the discount rate or cost of capital used in the calculation of NPV of any project is calculated after taking care of all the financial structure and tax adjustments of the business. This discounting factor also contains the risk and inflation adjustments which provide accurate time value of money. Another advantage of the NPV method of investment appraisal is that it uses all those cash flows, cash inflows and cash outflows, which are relevant to the specific project in making decisions. NPV shows the actual results and if it shows positive value in the result, it means that the project is showing the surplus in the worth of shareholder’s equity. Considering the whole life of the project is another advantage of NPV method. (Akers)
Internal Rate of Return is another way of calculating the feasibility of potential project in the future. Like NPV, IRR also uses the discounting factor to incorporate the time value of money to produce more accurate results for the management of the business. The decision rule for IRR is to accept the project of the IRR of the project is greater than the discounting factor or cost of capital. Another advantage of the IRR is that it displays the result in the form of percentage which is easy for the management to understand the results regarding the investments. To maximize the best results, IRR considers the whole life of the project and all the cash flows of the project. Like NVP, when the IRR produces the favorable results, it increases the worth of shareholder’s equity which is the ultimate goal of the management of business. ("Net present value,”)
The IRR has few disadvantages as well. The first disadvantage is that it does not give any absolute or complete number which shows the profit value. However, it gives the results in percentage and most of the time management argues on the portion of that percentage. For example, 10% of the $1,000 project is $100 which is too small. IRR is difficult to calculate and it hugely depends on the cash flows of the projects. ("Disadvantages of the,”)
The Cash payback period method can be used to analyze the actual time needed to recover the initial investment of the project. It assists management to assume the repayment period of the project which helps in analyzing the project with the risk, uncertainty and inflation rates of the business and industry. The payback period method does not incorporate important facts such as tax payments, capital allowances and other costs which incurred during the life of the project. It only deals or concern with the initial investment of the project and the annual cash inflows. The only difference between discounted payback period method and simple payback period method is that, the discounted payback period method uses the discounted rates during calculations to incorporate the time value of money. The purpose of the discounted payback period method is same as a simple payback period method which is to determine the actual repayment of the initial investment of the project to minimize the risk of the investments. (Woodruff)
References
Akers, H. Advantages & disadvantages of net present value in project selection. Retrieved from
http://smallbusiness.chron.com/advantages-disadvantages-net-present-value-project-selection-54753.html
Net present value and internal rate of return - advantages and disadvantages of npv and irr.
Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/4/npv-irr/advantages-disadvantages.aspx
Woodruff, J. Advantages & disadvantages of payback capital budgeting method.
Retrieved from http://smallbusiness.chron.com/advantages-disadvantages-payback-capital-budgeting-method-14206.html
Disadvantages of the irr method. Retrieved from
https://www.boundless.com/finance/capital-budgeting/internal-rate-of-return/disadvantages-of-the-irr-method/
