Question

Please explain why the net present value (NPV) method is preferred over the payback method when evaluating alternative capital budgeting projects.​

Answer 1

Net Present Value (NPV) method is preferred over the payback method because NPV method takes into consideration the time value of money whereas payback method does not take that account.

Time value of money the concept that $1 of today will not be $1 after one year. It would have increased by the interest rate prevailing in the market. Suppose if interest rate is 10%, then $10 would be $11 after one year.

Payback method does consider this attribute of money.

Lets take an example -

in this example, the project should be accepted as per payback period because we are able to recover the initial cost before the end of the project life but it has not considered time value of money.

on the other hand, NPV uses present values to depict the correct picture of the project that it is a loss project in actual and should not be undertaken.

That's why Net Present Value (NPV) method is preferred over Payback Period method.

REGARGING ALTERNATE CONTRACTS,

Lets see the next example -

in this case, as per payback period, project B is better since it is recovering its costs faster thsn project A whereas in reality project B is a loss project and project A is the profitable one. the correct decision is given by NPV and not payback period.

That's why Net Present Value (NPV) method is preferred over Payback Period method while evaluating alternative capital budgeting projects.