In our case, proposal A takes 4 years to recover the investment and proposal B takes only 3 years for the recovery of such investment. Accordingly the proposal B is ranked above the proposal A. The limitation in this method is that it does not consider time value of money.
Net present value is a discounted cash flow approach to capital budgeting. “If the present value of future cash flow is greater than the initial cost, the project is worth undertaking. On the other hand, if the present value is less than the initial cost, a project should be rejected because investor would lose money if the project were accepted.”(Angelico A. Groppelli and Ehsan Nikbakhat, page 159)ii Assessing from this point of view, both proposal have a positive net present value. But as the net present value of proposal A is more than that of proposal B. Accordingly NPV method ranks proposal A ahead of proposal B.
There are various shortcomings in methods of evaluation of capital projects that do not consider time value of money. It is generally felt that discounted cash flow methods provide a more objective basis for evaluating and selecting investment projects. These methods take account of both the magnitude and the timings of expected cash flows in each period of project’s life. Internal rate of return, like net present value method, is such a method that uses the discounted cash flow criteria to evaluate different capital projects. “The IRR for an investment is the discount (interest) rate that will make the present (or discounted) value of the cash flows from the operation equal to the initial outlay of the investment. An IRR above the minimum rate of return specified by management (called hurdle rate) is considered acceptable. When mutually exclusive projects are being compared, the project with highest IRR will be preferred.” (Ralph S.