Week 2 - Using NPV rule, Alternatives to NPV

Question 1

Payback period rule
3 weaknesses

Answer 1

= number of years it takes to recover the initial investment

1. ignores the TIME VALUE OF MONEY.
2. ignores the cash flows beyond the cutoff period.
3. It gives no indications on what the cutoff rule should be.

Question 2

Accounting rate of return
3 limitations

Answer 2

= average net income from project / average book value of investment

1. ignores the relevant cash flow from investment and instead considers the accounting profits (in particular, it depends critically on the accountants’ choice of a depreciation method).
2. ignores the TIME VALUE OF MONEY (as well as the risk of the project).
3. the choice of a yardstick is totally arbitrary

Question 3

Internal rate of return (IRR) rule
4 limitations

Answer 3

= the constant discount rate y which makes NPV = 0

Accept project if IRR > r (if there is a flat term structure)
*with flat term structure, IRR rule is equivalent to NPV rule

1. non-flat term structure: what r to compare against?
2. lending or borrowing: if latter, accept if IRR<r (swap the rule)
3. multiple IRRs or no IRRs
4. mutually exclusive project - IRR does NOT take SCALE into account while NPV does