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Pros and cons of financial tools

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Please discuss the pros and cons of each financial tool - NPV, IRR, payback, profitability index.

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Solution Summary

The following posting helps discuss the pros and cons of various financial tools. These include net present value, internal rate of return, payback and profitability index.

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Financial tools are capital budgeting techniques that are utilized in coming up with a capital budgeting decision. These could serve as a guide whether a potential project should be pursued or not. However, they are not absolute bases of capital budgeting decisions. They are still coupled with judgment of the financial manager.

The following are among the financial tools utilized:

1. Payback
This tool will show how long an initial investment will be recovered. It is normally expressed in years or a fraction thereof. It is computed by estimating the future cash flows that may result from the project in a given period (e.g. 1 year). Knowing the cash flows that a project will bring in during a particular period, the analyst can readily estimate the duration of which an initial investment is fully recovered.
Advantages:
- Simplicity of the process. By estimating how much will be recovered from the project in a given year, and by knowing the initial investment for the project, the payback period can be easily computed.
- This will be preferred by an investor that prioritizes on the period of recovery in deciding on a project.

Disadvantages
- The tool does not take into ...

Solution provided by:
Elisa Valdez, PhD
Education
  • Bachelor of Science in Business Administration, University of the Philippines
  • Master in Business Administration, Saint Mary's University
  • Doctor of Philosophy in Education, University of the Philippines
  • Doctor in Business Adminstration (IP), Polytechnic University of the Philippines
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