This is a Discussion Question. I just need a 250- 300 word Post

QUESTION

The finance department of a large corporation has evaluated a possible capital project using the NPV method, the Payback Method, and the IRR method. The analysts are puzzled, since the NPV indicated rejection, but the IRR and Payback methods both indicated acceptance. Explain why this conflicting situation might occur and what conclusions the analyst should accept, indicating the shortcomings and the advantages of each method. Assuming the data is correct, which method will most likely provide the most accurate decisions and why?
NPV method NPV is the most widely accepted method for capital budegting decisions. Using Net Present Value method we discount all cash flows to present using an appropriate discount rate (it should fall in line with the risk of the project). The rule says that one should accept all projects with NPV>0 and reject projects with NPV<0. The advantages are that it accounts for all the risk in the future cash flows. The disadvantages are that it does not tell us when the project will reach positive NPV ..Whether its 3 years, 5 years, 15 years. Another disadvantage is that there is no scarcity of capital and hence no capital rationing is required. IRR method This is the discount rate where NPV of returns is zero or also known as breakeven rate of interest. If IRR> opportunity cost of capital then accept all projects, if IRR

rate changes quite frequently. Payback Period This shows how soon we can recover our initial investment. Advantages are that the management can take simple go, no-go decisions quite easily. Disadvantages are that it does not take into accout the time value of money. NPV vs Payback Period It does not consider the cash flows after the Pay Back Period. Ignores time value of money. NPV vs IRR 1. It does not understand economies of scale and ignores dollar value of the project 2. IRR does not differentiate between discounting and reinvestment rates of cash flows . If the IRR of a very good project is say 37%, it is impracticalto invest at this rate Seeing all the methods NPV is the most desirable as it accounts for the time value of money with appropriate discount rates. It can evaluate small, medium and large projects.

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