Question

Compare and contrast the Payback method of capital budgeting and Net Present Value (NPV) method. Might one be a better alternative in some situations, if so which?

Answer 1

There are many methods of evaluating capital budgeting decisions. But the most widely used methods are net present value method and payback period method. Payback period method is simple to use and focus on liquidity of the project. But the main advantage of net present value method over payback period method is this method consider time value of money while the payback period method ignores time value of money. In any capital budgeting decision time value of money is an important factor to consider because cash flows from a capital budgeting project occur for many years. Another advantage of net present value method is that it consider all cash flows of the project but the payback period method ignores cash flow occurs after the payback period. This sometime does not provide the correct profitability of the project. But the payback period method has advantage of simplicity and its sole focus is on liquidity.

Out of the two methods, NPV method is more useful and is better alternative because of its consideration of time value of money which is an important factor and cannot be ignored.