You are on page 1of 2

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)

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