## Advantages and Limitations of Each Technique
### Payback Period
Advantages
- Easy to compute — simple arithmetic.
- Easy to understand — gives a quick estimate of how long to recoup the investment.
- Estimate of risk — longer paybacks are riskier; shorter paybacks are preferred where obsolescence is high or cash is tight.
Limitations
- Ignores time value of money — two projects with the same payback are treated as equal even if one front-loads its inflows.
- Ignores total profitability — counts cash only until the investment is recovered; cash flows after the payback point are ignored.
- Bias toward short payback — undervalues good long-term projects.
### Accounting Rate of Return (ARR)
Advantages
- Uses readily available data — drawn straight from financial reports.
- Consistency in evaluation — aligns with how operating results and management performance are measured.
- Considers entire project profitability — uses net income over the whole project life.
Limitations
- Ignores time value of money — treats all cash flows as equal in value.
- Depends on accounting procedures — net income/book value vary with chosen depreciation and accounting methods.
- Ignores cash flows — focuses on accounting net income rather than cash, which is the better performance measure.
- Excludes working capital and other outlays — uses only the asset's book value, overlooking other necessary investments.
### Net Present Value (NPV)
Advantages
- Considers time value of money.
- Considers the entire cash flow stream.
- Aligns with shareholders' wealth — directly shows the addition to wealth.
- Enables independent project evaluation — discounted values (in ₹) allow comparison across projects.
Limitations
- Difficult calculations — complex to compute accurately.
- Depends on accurate forecasting — accuracy hinges on estimating cash flows and the discount rate.
- Ignores differences in projects — being absolute, it doesn't reflect differences in initial outflow or scale of mutually exclusive projects.
### Profitability Index (PI)
Advantages
- Considers time value of money.
- Relative measure of profitability — compares PV of inflows to PV of outflows, so it scales for project size (addressing NPV's main weakness).
> Big picture: Non-discounted methods (Payback, ARR) are simple but ignore time value of money. Discounted methods (NPV, PI, IRR) are sounder; NPV is absolute, while PI and IRR are relative measures.