Each capital project evaluation method has certain underlying assumptions and limitations.

• Payback method >- Assumptions

❖ The speed of investment recovery is the most important investment criterion,

❖ The timing and amounts of cash flows can be accurately predicted.

❖ The risk is lower for projects with shorter paybacks.

>- Limitations

❖ Cash flows after payback are ignored.

❖ All cash flows are treated as determin¬ istic.

❖ The time value of money is ignored.

❖ Any managerial preferences in the pat¬ tern of cash flows are ignored.

❖ This method should be used in con¬ junction with another method because it ignores both the cash flows after the pay¬ back period is reached and the time value of money.

• Net present value method 5^ Assumptions

❖ The discount rate used is valid for that project.

❖ The timing and amounts of cash flows can be accurately predicted.

❖ Cash flows received from projects can be reinvested at the discount rate for the life of the project. When comparing proj¬ ects with unequal lives, the NPV method assumes that the cash inflows from the shorter project can be reinvested at the discount rate for the life of the longer project.

>- Limitations

❖ All cash flows are treated as determin¬ istic.

❖ The acmal rate of return for projects is not revealed.

❖ Any managerial preferences in the pat¬ tern of cash flows are ignored.

Profitability index

>- Assumptions

❖ The discount rate used is valid for that project.

❖ The timing and amounts of cash flows can be accurately predicted.

Cash flows received from projects can be reinvested at the discount rate for the life of the project. When comparing projects with unequal lives, the NPV method assumes that the cash inflows from the shorter project can be rein- vested at the discount rate for the life of the longer project. The present value of cash inflows rela- tive to the present value of the in- vestment measures an efficient use of capital. Limitations All cash flows are treated as determin- istic. The actual rate of return for projects is not revealed. Any managerial preferences in the pat- tern of cash flows are ignored. Actual dollars of net present value are ignored.

Internal rate of return method Assumptions The hurdle rate used is a valid return. benchmark. The timing and amounts of cash flows can be accurately predicted.

❖ The life of the project can be accurately predicted.
❖ Cash flows received from projects can be reinvested at the internal rate of re¬ turn for the life of the project. When comparing projects with unequal lives, the IRR method assumes that the cash inflows from the shorter project can be reinvested at the internal rate of return for the life of the longer project.
>- Limitations ❖ All cash flows are treated as detennin- istic.
❖ The acmal rate of return for projects is not revealed.
❖ Any managerial preferences in the pat¬ tern of cash flows are ignored.
❖ The dollar magnitude of return on a proj¬ ect is ignored.
❖ Multiple IRRs can be generated on the same project. LO.1