Question

Why Net Present Value (NPV) is better than Accounting Rate of Return (ARR) and Payback Period (PP). The word limit is 1000 words

Answer 1

Net present value method calculates the present value of the cash flows based on the opportunity cost of capital and derives the value which will be added to the wealth of the shareholders if that project is undertaken.

NET PRESENT VALUE VS. PAYBACK PERIOD

Payback period calculates a period within which the initial investment of the project is recovered.

The criterion for acceptance or rejection is just a benchmark decided by the firm say 3 Years. If the PBP is less than or equal to 3 Years,the firm will accept the project and else will reject it.

two major drawbacks with this technique –

1. It does not consider the cash flows after the PBP.
2. Ignores time value of money.

Net present value considers the time value of money and also takes care of all the cash flows till the end of life of the project.

NET PRESENT VALUE VS. INTERNAL RATE OF RETURN

The internal rate of return (IRR) calculates a rate of return which is offered by the project irrespective of the required rate of return and any other thing. It also has certain disadvantages discussed below:

1. IRR does not understand economies of scale and ignores the dollar value of the project. It cannot differentiate between two projects with same IRR but vast difference between dollar returns. On the other hand, NPV talks in absolute terms and therefore this point is not missed.
2. IRR assumes discounting and reinvestment of cash flows at the same rate. If the IRR of a very good project is say 35%, it is practically not possible to invest money at this rate in the market. Whereas, NPV assumes a rate of borrowing as well as lending near to the market rates and not absolutely impractical.
3. IRR enters the problem of multiple IRR when we have more than one negative net cash flow and the equation is then satisfied with two values, therefore, have multiple IRRs. Such a problem does not exist with NPV.

summary of above discussion is below

Net present value method calculates the present value of the cash flows based on the opportunity cost of capital and derives the value which will be added to the wealth of the shareholders if that project is undertaken.
NPV VS PBP	NPV VS IRR
drawback of PBP method	drawbacks of IRR method
1.It does not consider the cash flows after the PBP	1. IRR does not understand economies of scale
2.Ignores time value of money.	2. IRR assumes discounting and reinvestment of cash flows at the same rate
Net present value considers the time value of money and also takes care of all the cash flows till the end of life of the project	3. enters the problem of multiple IRR when we have more than one negative net cash flow