# Evaluating Capital Budgeting Techniques: Strengths & Weaknesses
Each capital budgeting appraisal method answers a slightly different question. To pick the right tool — and to write strong exam answers — you must know what each method does well and where it fails.
## 1. Payback Period
The payback period measures how long it takes to recover the original investment from cash inflows.
Limitations:
| Limitation | Why it matters |
|---|---|
| Ignores Time Value of Money | Two projects with the same payback period are treated as equal, even if one earns its inflows early and the other late. Early cash is worth more, but payback can't see this. |
| Ignores Total Profitability | It only counts cash flows up to recovery of the outlay and ignores everything after — so it cannot assess the project's overall profitability. |
| Focuses on Short Payback Periods | It rewards quick-recovery projects and may wrongly reject valuable long-term projects. |
## 2. Accounting Rate of Return (ARR)
ARR expresses average accounting profit as a percentage of the investment.
Advantages:
| Advantage | Explanation |
|---|---|
| Uses Readily Available Data | Built from figures already in the financial statements — no special data collection needed. |
| Consistency in Evaluation | Uses the same accounting basis as operating-result and management-performance assessment, keeping decisions consistent. |
| Considers Entire Project Profitability | Takes into account all net incomes over the whole life of the project. |
Limitations:
| Limitation | Explanation |
|---|---|
| Ignores Time Value of Money | Like payback, it treats all cash flows as equal in value regardless of timing. |
| Depends on Accounting Procedures | Relies on accounting numbers (e.g. depreciation method), so different policies give different ARRs for the same project. |
| Ignores Cash Flows | Uses net income, not cash flows — yet cash flow is the better measure of actual performance. |
| Excludes Working Capital & Outlays | Considers only the book value of the asset and overlooks working capital and other outlays essential to the project. |
## 3. Net Present Value (NPV)
NPV discounts all project cash flows to today and subtracts the initial outlay, giving the rupee value added to the firm.
Advantages:
| Advantage | Explanation |
|---|---|
| Considers Time Value of Money | Future cash flows are restated at their true present value. |
| Considers Entire Cash Flow Stream | Evaluates every cash flow over the project's life — a complete picture. |
| Aligns with Shareholders' Wealth | NPV directly shows the addition to shareholders' wealth, matching the core financial objective. |
| Enables Independent Project Evaluation | Because it works in current rupees, each project can be evaluated and compared on its own. |
Limitations:
| Limitation | Explanation |
|---|---|
| Difficult Calculations | Discounting is complex and error-prone if done by hand. |
| Depends on Accurate Forecasting | Accuracy hinges on correctly estimating cash flows and the discount rate. |
| Ignores Differences in Projects | Being an absolute measure, NPV ignores differences in the size of initial outflows of mutually exclusive projects. |
## 4. Profitability Index (PI)
PI = Present Value of Inflows ÷ Present Value of Outflows. It is the relative cousin of NPV.
Advantages:
| Advantage | Explanation |
|---|---|
| Considers Time Value of Money | Uses discounted cash flows. |
| Relative Measure of Profitability | Compares PV of inflows to PV of outflows, so it ranks projects per rupee invested — useful where NPV (absolute) cannot. |
Limitations:
| Limitation | Explanation |
|---|---|
| Fails in Capital Rationing | Ineffective when capital is rationed, especially with indivisible projects. |
| Excludes Smaller Projects | Picking one large high-NPV project may shut out several small projects whose combined NPV is higher. |
| Ignores Future Opportunities | A lower-PI project may time its cash flows so a further project can be taken later, giving a higher total NPV. |
| Requires Comprehensive Evaluation | PI cannot be used in isolation; all alternatives must be weighed together. |
## Key Takeaway
- Payback & ARR are simple but ignore the time value of money.
- NPV is the theoretically superior measure (absolute wealth added) but is size-blind.
- PI complements NPV as a relative measure but breaks down under capital rationing.