Comparison of Capital Budgeting Methods
Prerequisites
Before studying this chapter, make sure you have studied all individual methods:
- Payback & ARR (Traditional)
- NPV & IRR (Modern/DCF)
1. Traditional vs Modern Methods
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2. Detailed Method Comparison Table
| Feature | Payback Period | ARR | NPV | IRR | Profits Index (PI) |
|---|---|---|---|---|---|
| Concept | Time to recover cost | Return on Investment | Wealth Addition | % Return Rate | Efficiency Ratio |
| Input Data | Cash Flows | Accounting Profit | Cash Flows | Cash Flows | Cash Flows |
| Time Value | Ignored | Ignored | Considered | Considered | Considered |
| Decision | < Standard | > Target Rate | Positive (> 0) | > Cost of Capital | > 1.0 |
| User | Small Firms | Accountants | Large Firms | Banks/Managers | Fund Managers |
3. Which Method is Best?
Net Present Value (NPV) is widely considered the best theoretical method because:
- It assumes reinvestment at the Cost of Capital (which is realistic).
- It directly measures the value added to shareholders (Wealth Maximization).
- It always gives the correct decision for mutually exclusive projects.
Why utilize IRR then? Managers prefer percentages. Saying "This project gives 15% return" is easier to understand than "This project adds ₹45,200 to wealth."
Exam Pattern Questions and Answers
Question 1: "Compare NPV and Payback Period methods." (6 Marks)
Answer: 1. Basis of Evaluation:
- Payback: Evaluates based on how quickly the initial investment is recovered (Liquidity).
- NPV: Evaluates based on how much value is added to the firm in total (Profitability).
2. Time Value of Money:
- Payback: Ignores time value; treats year 1 cash same as year 5 cash.
- NPV: Discounts future cash flows; explicitly recognizes money's time value.
3. Coverage:
- Payback: Ignores cash flows occurring after the payback period.
- NPV: Considers cash flows over the entire life of the project.
Conclusion: NPV is superior to Payback method.
Summary
- Payback: Speed of return.
- ARR: Book profit.
- NPV: Total wealth addition (Best).
- IRR: Percentage return.
- PI: Return per rupee (Best for Capital Rationing).
Exam Tip
If asked "Which method is best?", always answer NPV. Give three reasons: Time Value, Wealth Maximization, and Reinvestment Assumption.
Quiz Time! 🎯
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