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FM Assignment

The document discusses various capital budgeting techniques including payback period, accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), and profitability index. It provides advantages and disadvantages of each method. Specifically, it notes that payback period is simple but ignores time value of money, while NPV and IRR both consider time value of money but can provide different results for projects of different sizes. IRR is preferred by some over NPV as it expresses returns as a percentage rather than dollars, but NPV is generally considered a better measure.

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Muhammad Haris Muhammad Aslam
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83 views

FM Assignment

The document discusses various capital budgeting techniques including payback period, accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), and profitability index. It provides advantages and disadvantages of each method. Specifically, it notes that payback period is simple but ignores time value of money, while NPV and IRR both consider time value of money but can provide different results for projects of different sizes. IRR is preferred by some over NPV as it expresses returns as a percentage rather than dollars, but NPV is generally considered a better measure.

Uploaded by

Muhammad Haris Muhammad Aslam
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Question no.

5:

Payback Period:
Payback method helps in revealing the payback period of an investment.  Payback period (PBP)
is the time (number of years) it takes for the cash flows of incomes from a particular project to
cover the initial investment.

Advantages of Payback Period:


1. This is among the most significant advantages of the payback period. The method needs very
few inputs and is relatively easier to calculate than other capital budgeting methods. All that
you need to calculate the payback period is the project’s initial cost and annual cash flows.
Though other methods also use the same inputs, they need more assumptions as well.
2. Since the payback period is easy to calculate and need fewer inputs, managers are quickly
able to calculate the payback period of the projects. This helps the managers to make quick
decisions, something that is very important for companies with limited resources.
3. The payback period is crucial information that no other capital budgeting method reveals.
Usually, a project with a shorter payback period also has a lower risk. Such information is
extremely crucial for small businesses with limited resources. Small businesses need to
quickly recover their cost so as to reinvest it in other opportunities.
4. The payback method is very useful in the industries that are uncertain or witness rapid
technological changes. Such uncertainty makes it difficult to project the future annual cash
inflows. Thus, using and undertaking projects with short PBP helps in reducing the chances
of a loss through obsolescence.

Disadvantages of Payback Period:


1. This is among the major disadvantages of the payback period that it ignores the time value
of money  which is a very important business concept. As per the concept of the time value
of money, the money received sooner is worth more than the one coming later because of its
potential to earn an additional return if it is reinvested.
2. The payback method considers the cash flows only till the time the initial investment is
recovered. It fails to consider the cash flows that come in subsequent years. Such a limited
view of the cash flows might force you to overlook a project that could generate lucrative
cash flows in their later years.
3. The payback method is so simple that it does not consider normal business scenarios.
Usually, capital investments are not just one-time investments. Rather such projects need
further investments in the following years as well. Also, projects usually have irregular cash
inflows.
4. A project with a shorter payback period is no guarantee that it will be profitable. What if the
cash flows from the project stop at the payback period, or reduces after the payback period.
In both cases, the project would become unviable after the payback period ends.
ARR:
Accounting rate of return (ARR) reflects the percentage rate of return expected on an investment,
or asset, compared to the initial investment's cost. The ARR formula divides an asset's
average revenue by the company's initial investment to derive the ratio or return that one may
expect over the lifetime of the asset, or related project. ARR does not consider the time value of
money or cash flows, which can be an integral part of maintaining a business.
Advantages of ARR:
1. It is very easy to calculate and simple to understand like pay back period. It considers the
total profits or savings over the entire period of economic life of the project.
2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation.
This is a vital factor in the appraisal of a investment proposal.
3. This method facilitates the comparison of new product project with that of cost reducing
project or other projects of competitive nature.
4. This method gives a clear picture of the profitability of a project.
5. This method alone considers the accounting concept of profit for calculating rate of return.
Moreover, the accounting profit can be readily calculated from the accounting records.
Disadvantages of ARR:
1. The results are different if one calculates ROI and others calculate ARR. It creates problem
in making decisions.
2. This method ignores time factor. The primary weakness of the average return method of
selecting alternative uses of funds is that the time value of funds is ignored.
3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the
management.
4. This method does not consider the external factors which are also affecting the profitability
of the project.
5. It does not taken into the consideration of cash inflows which are more important than the
accounting profits.

Question no. 6(a):


NVP:
Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of a
business, investment security, capital project, new venture, cost reduction program, and anything
that involves cash flow.

IRR:
Internal Rate of Return (IRR) is a financial measure used to evaluate projected cash flow results
and to compare the feasibility of a project/investment. IRR is generally used with other financial
measures such as Net Present Value (NPV) and Return on Investment (ROI). IRR is defined as
the discount rate at which you can ensure that your investment makes more money than its actual
cost. In other words, it is the rate at which NPV is zero. If the IRR value is less than the cost of
capital, then the project should be rejected Else, the project can be accepted.

(b)
The internal rate of return (IRR) rule is a guideline for deciding whether to
proceed with a project or investment. The rule states that a project should be
pursued if the internal rate of return is greater than the minimum required rate of
return. That is, the project looks profitable.

On the other hand, if the IRR is lower than the cost of capital, the rule declares
that the best course of action is to forego the project or investment.

NPV is an indicator of how much value an investment adds. In financial theory, if there is a
choice between two mutually exclusive alternatives, the one yielding the higher NPV should
be selected and generally speaking the following is true:

 If the NPV of an investment is greater than zero, accept!


 If the NPV of an investment is less than zero, reject!

(c)
Advantages of NPV:
1. The primary benefit of using NPV is that it considers the concept of the time value of
money i.e., a dollar today is worth more than a dollar tomorrow owing to its earning
capacity. The computation under NPV considers the discounted net cash flows of an
investment to determine its viability.
2. NPV method enables the decision-making process for companies. Not only does it help
evaluate projects of the same size, but it also helps in identifying whether a particular
investment is profit-making or loss-making.

Disadvantages of NPV:
1. The entire computation of NPV rests on discounting the future cash flows to its present
value using the required rate of return. However, there are no guidelines as to the
determination of this rate. This percentage value is left to the discretion of companies,
and there could be instances wherein the NPV was inaccurate due to an erroneous rate of
returns.
2. Another disadvantage of NPV is that it cannot be used to compare projects of different
sizes. NPV is an absolute figure and not a percentage. Therefore, the NPV of larger
projects would inevitably be higher than a project of a smaller size. The returns of the
smaller project may be higher than its investment, but overall the NPV value might be
lower.
3. NPV only takes into account the cash inflows and outflows of a particular project. It does
not consider any hidden costs, sunk costs, or other preliminary costs incurred about the
specific project. Therefore, the profitability of the project may not be highly accurate.

(d)
Advantages of IRR:
1. It considers the time value of money even though the annual cash inflow is even and
uneven.
2. The profitability of the project is considered over the entire economic life of the project.
In this way, a true profitability of the project is evaluated.
3. There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal
Rate of Return method is better than Net Present Value method.

Disadvantages of IRR:
1. This method assumed that the earnings are reinvested at the internal rate of return for the
remaining life of the project. If the average rate of return earned by the firm is not close
to the internal rate of return, the profitability of the project is not justifiable.
2. It involves tedious calculations.
3. The results of Net Present Value method and Internal Rate of Return method may differ
when the projects under evaluation differ in their size, life and timings of cash inflows.

(e)
In capital budgeting, there are a number of different approaches that can be used
to evaluate a project. Each approach has its own distinct advantages and
disadvantages. Most managers and executives like methods that look at a
company's capital budgeting and performance expressed in percentages rather
than dollar figures. In these cases, they tend to prefer using IRR or the internal
rate of return instead of the NPV or net present value. But using IRR may not
produce the most desirable results.

Question no. 7:
Advantages of profitability index:
1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of cash outlay of different project.
4. PI ascertains the exact rate of return of the project.
Disadvantages of Profitability Index (PI):
1. It is difficult to understand interest rate or discount rate.
2. It is difficult to calculate profitability index if two projects having different useful life.

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