AF3313 Business Finance
For the NPV accounting method, the advantages are, firstly, it considers the time value of money, it will discount the cash flows properly in order compare different cash flow and make correct decision. Secondly, it use cash flows and also all the cash flows of the project will be considered. Also, it will consider the risk of future cash flows through the cost of capital. However, as an investment criterion, NPV wholly excludes the value of any real options that may exist within the investment. For example, it does not consider how long is the project pay back which may be the important consideration when a company decide whether to ...view middle of the document...
For the Internal Rate of Return method (IRR), the advantages are, firstly, it uses cash flow and all cash flow is considered, the discount rate was regarded as the required return rate and to be compared with the IRR. Secondly, the criteria of IRR is clear and reasonable which is accept the project when IRR is higher than or equal to the required return rate. It is a simple way to communicate the value of a project to someone who does not know the estimation details.
However, it has a number of problems when using IRR as an investment selection criteria. First, IRR has a scale problem, it only consider the per year return rate instead of the actual value of the project which means that Higher IRR does not guarantee higher NPV because the project with a higher IRR could be of a smaller scale. Second, multiple IRRs may be occurred when there are “N” sign changes in cash flows over life of project. Also, IRR may not exist due to the mathematical problem. Moreover, there is also timing problem when using IRR method, it will hard to make decision when choosing mutually exclusive projects.
For Profitability Index (PI) method, the advantages are easy to understand and communicate. Also, all cash flow are considered and it is useful when available investment funds are limited. However, it similar with IRR, it also ignores sizes of cash flows and has a scale problem.
In this question, we know that there are 2 stocks in the market, Stock A & Stock B. Stock A has a higher expected return which is 10% and a lower standard deviation which is 8% per year. On the contrary, Stock B has a...