Merits and demerits of different instruments of capital budgeting

Merits of payback period:

1. Provides an indication of a project’s risk and liquidity.
2. Easy to calculate and understand.
3. Quick solution
4. Useful in case of uncertainty.
Demerits of payback period:
1. Ignores the Time value of money.
2. Ignores CFs occurring after payback period.
3. No specification of acceptable payback.
4. Not realistic and ignores profitability.

Demerits of discounted payback period:

1. Fails to determine whether the investment made will increase the firm’s value or not.
2. It does not consider the project that can last longer than the payback period. It ignores
all the calculations beyond the discounted payback period.
3. The major problem with using this payback period is that it does not give the manager
the exact information required to decide on investing in a project. The business
manager must assume the interest rate or the cost of capital to determine the payback
period.
4. The calculation for discounted payback period can get complex if there are multiple
negative cash flows during an investment period.

Merits of IRR:
1. Time value of money being considered while calculating IRR.
2. Simple to in interpret after the IRR is calculated.
3. No requirement of finding hurdle rate.
4. Managers make rough estimate of Required Rate of Return.
Demerits of IRR:
1. Economies of scale is ignored.
2. Mutually exclusive projects are ignored.
3. Dependant or contingent project are being ignore while IRR.
4. Different terms of projects are not considered by IRR method.
Net present value: Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period.

Merits of NPV:
1. It considers the time value of money.
2. Helpful in decision making.
Demerits of NPV:
1. The calculation of rate of return does not have set guidelines.
2. Projects may be incomparable because of different investment terms and sizes.
3. Hidden costs are not considered.

Merits of PI:
1. Simple and widely used method
2. Considers time value of money.
3. Easy to make decision.
4. Accurate rate of return.
Demerits of PI:
1. Difficult to estimate discount rate.
2. Possibility of incorrect decision.
3. Difficult to make comparison.
Accounting Rate of Return: The accounting rate of return (ARR) is a formula that reflects the
percentage rate of return expected on an investment or asset, compared to the initial
investment's cost.

Merits of ARR:
1. The ARR concept is a familiar concept to return on investment (ROI) or return on
capital employed.
2. It is easier to calculate and simple to understand like payback period.
 3. It considers accounting concept of profit for calculating rate of return. The
accounting profit can be readily calculated from the accounting records.
4. Total profits or savings over the entire period of economic life of the project is
estimated under ARR method which gives clear picture of profitability from the
project.
5. It is a simple capital budgeting technique and is widely used to provide a guide to
how attractive an investment project is.

Demerits of ARR:
1. This method is based on profits rather than cash flow. Therefore, it can be affected
by non-cash items such as the depreciation and bad debts when calculating profits.
2. The change of methods for depreciation can lead to different outcomes.
3. This technique does not adjust for the risk to longer term forecasts.
4. This method ignores time factor. The profits are earned as a 14.33% rate of return in
20 years may be better than 8% rate of return for 5 years under ARR method. This is
not proper because longer the term of the project, greater is the risk involved.
5. This method does not consider the external factors which are also affecting the
profitability of the project.

Modified Internal rate of return: The modified internal rate of return (MIRR) assumes that
positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are
financed at the firm's financing cost.
Merits of MIRR:
1. MIRR considers all cash flows of the project while NPV deducts the present cash
flow from future cash flows
2. MIRR and NPV consider the time value of money
3. MIRR and NPV are time-adjusted methods of measuring investments.
Demerits of MIRR:
1. MIRR and NPV lead to the same decision in the case of independent projects and
require an estimate of the cost of capital to decide.
2. Potential conflict with the NPV and MIRR happens due to differences in the project
scale.
3. Both MIRR and NPV are difficult to interpret and calculate and are closely related to
investment criteria.