NPV

Question 1

Why is NPV superior?

Answer 1

1.NPV uses cash flows. Cash flows from a project can be used for other corporate purposes (such as dividend payments, other capital budgeting projects, or payments of corporate interest). By contrast, earnings are an artificial construct. Although earnings are useful to accountants, they should not be used in capital budgeting because they do not represent cash.
2. NPV uses all the cash flows of the project. Some alternative approaches ignore cash flows beyond a particular date; beware of these approaches
3. NPV discounts the cash flows properly. Other approaches may ignore the time value of money when handling cash flows. Beware of these approaches, as well.

Question 2

Problems with Payback

Answer 2

1. A problem with the payback method is that it does not consider the timing of the cash flows within the payback period.
2. Another problem with the payback method is that it ignores all cash flows occurring after the payback period. Because of the short-term orientation of the payback method, some valuable long-term projects are likely to be rejected. The NPV method does not have this flaw because, this method uses all the cash flows of the project.
3. Arbitrary Standard for Payback Period - Using an arbitrary standard for the payback period can pose several problems and limitations in the investment decision-making process:
   Ignoring the Time Value of Money and Risk Disregard: The payback period does not explicitly account for project risk or the variability of cash flows

Question 3

IRR

Answer 3

The basic rationale behind the IRR method is that it provides a single number that summarizes the merits of a project. This number does not depend on the interest rate prevailing in the capital market. That is why it is called the internal rate of return: The number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project.

Question 4

Independent project

Answer 4

An independent project is one whose acceptance or rejection independent of the acceptance or rejection of other projects. example, imagine that McDonald’s is considering putting hamburger outlet on a remote island. Acceptance or rejection of unit is likely to be unrelated to the acceptance or rejection of other restaurant in its system.