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Advantage and disadvantages of the different capital budgeting

techniques
Prepared by Pamela Peterson-Drake, Florida Atlantic University

Payback Period

Advantages Disadvantages
1. Simple to compute 1. No concrete decision criteria to indicate
2. Provides some information on the risk whether an investment increases the firm's
of the investment value
3. Provides a crude measure of liquidity 2. Ignores cash flows beyond the payback
period
3. Ignores the time value of money
4. Ignores the risk of future cash flows

Discounted Payback
Period
Advantages Disadvantages
1. No concrete decision criteria that indicate
whether the investment increases the firm's
1. Considers the time value of money value
2. Considers the riskiness of the project's 2. Requires an estimate of the cost of capital in
cash flows (through the cost of capital) order to calculate the payback
3. Ignores cash flows beyond the discounted
payback period

Net Present Value

Advantages Disadvantages
1. Tells whether the investment will
increase he firm's value 1. Requires an estimate of the cost of capital
2. Considers all the cash flows in order to calculate the net present value.
3. Considers the time value of money 2. Expressed in terms of dollars, not as a
4. Considers the risk of future cash flows percentage.
(through the cost of capital)
Profitability Index

Advantages Disadvantages
1. Tells whether an investment increases
the firm's value
2. Considers all cash flows of the project 1. Requires an estimate of the cost of capital in
3. Considers the time value of money order to calculate the profitability index
4. Considers the risk of future cash flows 2. May not give the correct decision when used
(through the cost of capital) to compare mutually exclusive projects.
5. Useful in ranking and selecting
projects when capital is rationed

Internal Rate of Return

Advantages Disadvantages
1. Tells whether an investment increases 1. Requires an estimate of the cost of capital in
the firm's value order to make a decision
2. Considers all cash flows of the project 2. May not give the value-maximizing decision
3. Considers the time value of money when used to compare mutually exclusive
4. Considers the risk of future cash flows projects
(through the cost of capital in the 3. May not give the value-maximizing decision
decision rule) when used to choose projects when there is
capital rationing
4. Cannot be used in situations in which the sign
of the cash flows of a project change more
than once during the project's life

Modified Internal Rate of


Return
Advantages Disadvantages
1. Requires an estimate of the cost of capital in
1. Tells whether an investment increases
order to make a decision
the firm's value
2. May not give the value-maximizing decision
2. Considers all cash flows of the project
when used to compare mutually exclusive
3. Considers the time value of money
projects
4. Considers the riskiness of future cash
3. May not give the value-maximizing decision
flows (through the cost of capital in
when used to choose projects when there is
the decision rule)
capital rationing