Comment on the following: Since net present value (NPV) method is considered by many people to be the best form of analysis when analysing investment opportunities, we should always only use the net present value (NPV) method when making capital budgeting decision

NPV is the most acceptable capital budgeting rule as it has many advantages but it is not correct to say that we should always use the NPV method when making capital budgeting decisions.

The decision taken in NPV is based on absolute returns. The decision rule in NPV is "Accept the project where NPV is positive and reject where NPV is negative."

It ignores difference in initial outflows, size of different proposals, lives of the project, etc.

For example-

If NPV of project A is 10000$ with initial investment of 100000 $

and NPV of Project B is 7000 $ with initial investment of 50000$.

Based on NPV rule, project A should have been accepted as NPV of project A is greater than project B.

But if we check, the return on project B is greater as it is generating 7000 $ with half of the capital investment needed for project A.

If there is capital rationing, project B will be providing more returns to the company. Hence project B must have been accepted.

When project have different lives, NPV rule is biased in favour of long term projects. This limitation is overcome by profitability index method.

PI is relative measure which takes into account the different initial investment requirement of the project.

The unequal live limitation can be overcome by using equivalent annual NPV method.