Question

What are the payback and NPV (net present value) methods of evaluating capital projects? Which is considered the best evaluation method, and why is one better than the other?

Answer 1

Payback and NPV methods are the measure for evaluating an capital project.
Payback deals with the time taken by project to pay back cost of initial investment.On the other hand NPV (Net Present Value) is the
present value of all cash flows associated with the project.
Let us consider an example for this purpose that is discounted at 10%:
	Year	Cash flows	Cumulative cash flows			Discount factor		Present Value
	a	b		c		d=1.10^-a		e=b*d
	0	$ -1,00,000		$ -1,00,000		1.0000		$       -1,00,000
	1	50,000		$     -50,000		0.9091		45,455
	2	30,000		$     -20,000		0.8264		24,793
	3	22,000		$         2,000		0.7513		16,529
	4	15,000		$      17,000		0.6830		10,245
		Net Present Value						-2,978
	Payback Period		=	2+(20000/22000)		=	2.91 Years
	From the above example, It is observed that project is paying back initial investment in 2.91 years of 4 years project.
	So, on the basis of Payback ,project is acceptable.
	But, when calculating Net Present Value from the project, it is found that project is giving a negative Net Present Value.
	It means as of today we are losing $ 2978 from the project.So, Project will be rejected.
	In such case , NPV method is acceptable because the objective of capital project is to create money from project
	and project is not creating any money and hence it will be rejected by considering NPV method