Persistence of Inconsistency in Investment Evaluation Methods

The Payback period and the IRR methods are inferior to the NPV method, but firms still use these methods. Provide a rationale for this inconsistency. Why are they inferior to the NPV method? Financial mangers often use different techniques to evaluate the economic attractiveness of the potential capital required to make an investment. Firms that operate businesses on a large scale like oil and gas Exploration Companies often uses NPV in comparison with small business firms that often prefer IRR and Payback due to the lack of capital and also due to the small scale of business.

Moreover, NPV provides viable results where the firm uses the conservative approach to assess the project. From the perspective of those firms that prefer NPV because it debates over cash flows and not accounting earnings and NPV provides viable results in making the appropriate decision for the company (Myers, Brealey and Marcus, 2001). To use the payback rule a firm has to decide on an appropriate cut-off period.

Get quality help now

writer-Charlotte

Verified writer

Proficient in: Business

4.7 (348)

“ Amazing as always, gave her a week to finish a big assignment and came through way ahead of time. ”

+84 relevant experts are online

Hire writer

If it uses the same cut-off regardless of project life, it will tend to accept too many short-lived projects and reject too many long-lived ones.

The payback rule will bias the firm against accepting long-term projects because cash flows that arrive after the payback period are ignored (Myers, Brealey and Marcus, 2001). IRR method is not appropriate for rating mutually exclusive projects. The businesses related to construction might face different macro-level factors like increase in cement prices, higher interest rates, etc that make a negative reflection on the future cash flows of the company.

Moreover, due to this complexity most of the firms are hesitant in applying the IRR and also it distracts the financial decision of the company (Myers, Brealey and Marcus, 2001).

In case of a company that manufactures parts for the automotive industry, the most obvious investment would be new and better functioning machinery, i. e. improvement in infrastructure. These machinery would be expected to generate future cash flows. Now, according to my understanding NPV should be the ideal investment appraisal technique for such a firm. As the firm would be interested in knowing whether the new machine will generate positive net cash flows in future, thereby maximizing shareholder wealth. References Brealey, Richard A. , Stewart C. Myers, Alan J. Marcus, (2001). Fundamentals of Corporate Finance. New York. McGraw Hill