DISCUSSION QUESTION 1
The conflicting situation can be understood by examining the meritsand drawbacks of each of the three capital budgeting decisions. Thepayback method is simple to calculate and interpret. It also providesa reliable measure of the liquidity and risk of the project. However,the payback method overlooks the time value of money. In this regard,it does not consider the risk associated with future cash flows. Inaddition, the method ignores the value of cash flows after thepayback period (Gotze, 2015). Consequently, it does not provide thebest guidance when determining the significance of a particularinvestment.
On the other hand, the net present value can be used to decidewhether an investment will add value to the firm. It also considersall cash flows from the initial investment. Furthermore, the NPVfactors the time value of money in its calculations. Moreover, themethod uses the cost of capital to ascertain the risk of subsequentcash flows. Nevertheless, the NPV cannot be expressed as a percentage(Gotze, 2015). Besides, it must be supplemented with the cost ofcapital before obtaining the required value.
In comparison to the payback method, the internal rate of returninforms whether an investment would be value-adding. It alsoconsiders all cash flows as well as the time value of money.Moreover, IRR uses the cost of capital obtained from the decisionrule while estimating the risk of future returns. Unlike the NPV, theIRR can be expressed as a percentage. However, it cannot be used todetermine the investment decision that maximizes value (Goel, 2015).It can also provide a misleading result since it uses a singlediscount rate in evaluating cash flows.
Therefore, the disparities can be explained by the fact that theproject has multiple cash flows obtained at different discount rates.The payback method indicated acceptance since the period was shorterthan the maximum acceptable duration (Goel, 2015). The NPV showedrejection since it resulted in a negative value. Although the IRRindicated acceptance, the NPV provides the most accurate decisions.This is because the NPV considers the discount rates of individualcash flows (Goel, 2015). Consequently, the capital project should berejected.
Goel, S. (2015). Capital budgeting. New York, NY: BusinessExpert Press.
Gotze, U. (2015). Investment appraisal: Methods and models.New York, NY: Springer.