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...