Question

What are the advantages of using net present value and internal rate of return methods to evaluate capita budgeting decisions instead of the payback period?

Answer 1

Advantages of using NPV and IRR over Payback Period:

Payback period refers to the time within which the project is expected to recover all its cash outflows associated with the respective project but without considering time value of money. So, shorter the payback period, higher the acceptibility of the project because all cash outflows are recovered in short period so that uncertainity of cash flows after the payback period need not be worried about by the management. However, that is the drawback of using payback too.

IRR stands for Internal Rate of Return which is the rate at which project's Net Present Value (NPV) is zero. In other words, IRR is the rate which makes present value of future cash flows equals to initial outlay associated with. Higher the IRR, higher the acceptability of the project. In other words, if IRR calculated is more than cost of capital associated with the project, it shall be accepted; otherwise, rejected.

NPV stands for Net Present Value which discounts future cash inflows to current worth using cost of capital as the discount rate or hurdle rate. Initial cash outflow is subtracted from present value of future cash flows to calculate NPV. Positive NPV means that the project is capable of recovering all its cash outlays before expiry of the life of the project itself even after considering time value of money.

Using NPV and IRR as project evaluation tools instead of using Payback period has a main advantage of consideration of time value of money. That is, worth of $1 available on hand today will always be higher than the worth of $1 expected to be held on hand in future date due to various factors such as inflation, market interest rate, etc. Secondly, both NPV and IRR consider all cash flows associated with the projects, taken up for evaluation, during entire life of the project but payback period ignores cash flows that occur after the life of the project.