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Advantage and disadvantages of the different capital budgeting techniques Prepared by Pamela Peterson-Drake, Florida Atlantic University

Payback Period
Advantages
1. Simple to compute
2. Provides some information on the risk of the investment
3. Provides a crude measure of liquidity

Disadvantages
1. No concrete decision criteria to indicate whether an investment increases the firm's value 2. Ignores cash flows beyond the payback period 3. Ignores the time value of money
4. Ignores the risk of future cash flows

Discounted Payback Period
Advantages

Disadvantages
1. No concrete decision criteria that indicate whether the investment increases the firm's
1. Considers the time value of money value 2. Considers the riskiness of the project's
2. Requires an estimate of the cost of capital in order to calculate the payback cash flows (through the cost of capital)
3. Ignores cash flows beyond the discounted payback period

Net Present Value
Advantages
1. Tells whether the investment will increase he firm's value
2. Considers all the cash flows
3. Considers the time value of money
4. Considers the risk of future cash flows
(through the cost of capital)

Disadvantages
1. Requires an estimate of the cost of capital in order to calculate the net present value.
2. Expressed in terms of dollars, not as a percentage. Profitability Index
Advantages
Disadvantages
1. Tells whether an investment increases the firm's value
1. Requires an estimate of the cost of capital in
2. Considers all cash flows of the project order to calculate the profitability index
3. Considers the time value of money
4. Considers the risk of future cash flows
2. May not give the correct decision when used
(through the cost of capital) to compare mutually exclusive projects.
5. Useful in ranking and selecting projects when capital is rationed

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