Advantages and Disadventages

Topics: Net present value, Investment, Rate of return Pages: 2 (575 words) Published: February 20, 2013
Advantage of NPV:
 It ensures that the firm reaches an optimal scale of investment.

Disadvantage of IRR:
 It expresses the return in a percentage form rather than in terms of absolute dollar returns, e.g. the IRR will prefer 500% of $1 to 20% return on $100. However, most companies set their goals in absolute terms and not in % terms, e.g. target sales figure of $2.5 million.

Disadvantages of the payback method:
 It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.  It ignores the time value of money. This means that it does not take into account the fact that $1 today is worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a year's time.  It is unable to distinguish between projects with the same payback period.  It may lead to excessive investment in short-term projects.

Advantages of the payback method:
 Payback can be important: long payback means capital tied up and high investment risk. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.

Disadvantages of ROI:
 It does not take account of the timing of the profits from an investment.  It implicitly assumes stable cash receipts over time.
 It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments.  It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.  It takes no account of the length of the project.

 it ignores the time value of money.
Benefits of the Payback Method
-Highlights liquidity. The payback method shows, in effect, how quickly cash will re- turn to the firm. This information can be useful if the firm might be short on cash in...
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