Advantages and Disadvantages of NPV, IRR, ARR and Payback rule

As capital budgeting decisions often involve major undertakings, therefore risk and rewards had to be carefully weighed i.e. £17 billion High Speed Rail 2. The investment appraisal techniques are analysed as below:

Accounting Rate of Return

Advantages: (Pike, 2012:95-96)

·         Calculations are simple and quick

·         It  gives a percentage value – easy to understand

·         It considers all cash flow arising during the life span of the project

Disadvantages: (Ross, 2011:239-241)

·         It uses accounting profits which is open to managerial manipulations

·         It ignores timing of profits as it uses average profits

·         The target rate of return is arbitrage

Payback method

Advantages: (Berk, 2011:164-171)

·         Calculations are simple and quick.

·         Tendency to accept low risk projects.

Disadvantages: (Ross, 2011:236-239)

·         It does not recognise time value of money and ignores cost of capital.

·          Valuable long term projects are likely to be rejected as it does not considers cash flows after the payback period

·         The payback cut off date is arbitrary

Net Present Value

Advantages: (G.Arnold, 2008:61-78; P.Atrill, 2012:136-145)

·         It recognises the time value of money

·         It can handle unconventional cash flows

·         Cash flows are used instead of accounting profits

·         All relevant cash flows throughout the project life is considered in the calculations

Disadvantages: (Ross, 2011:138)

·         Calculations may be tedious as it involves discounting

·         Estimation of the cash inflows and outflows value over the project life is difficult

Internal Rate of Return

Advantages: (P.Atrill, 2012:157)

·         It is expressed in percentage terms – easy to understand

·         It takes into account time value of money

Disadvantages: (G.Arnold, 2008:61-78)

·         It may be time consuming using trial and error approach to  derive the required discount rate

·         It can’t be used in the event of changing cash flows.

·         It produces the same recommendation and does not consider different discount rates.