Question

Both the Simple Payback Rule and Net Present Value are useful techniques in determining whether a project or investment will result in a net profit or a loss. Which calculation would you choose to use when capital budgeting? Using either method, explain how you would adjust for projects with differing risks?

Answer 1

In the simple payback rule, you compute the period within which the simple/ undiscounted cash inflows recover the initial capital outlay. Whereas in case of Net present value method, you compare the present value of cash inflows with the present value of cash outflows and compute whether you have a positive or negative NPV. Now, I would prefer NPV method, simply because it takes into account the time value of money. It computes the present value of cash inflows and outflows whereas in case simple payback period, the time value of money. Time value of money is important because you need to see whether a certain project is given a positive outcome using the required rate of return when discounted at that rate.

If you are using NPV method, a proper way to adjust for risk would be to incorporate the risk factor in the discount rate that you are using to compute present value of cash inflows and outflows. Whereas in case of payback period, you would adjust the acceptable payback period to the firm. In both the methods, the cash inflows and outflows can also be adjusted.