Question

MANAGERIAL ECONOMICS (4)

What is the main difference between payback period and the net present value methods of capital budgeting? Why should the time value of money be considered in evaluating projects? Give examples. Explain extensively.

Answer 1

Payback period is the period required by the project to recover the cost of investment or the initial amounts invested in the project. The longer the payback period the less attractive the project is. NPV is the method in which the difference between the present value of the future cash inflows and the present value of the future cash outflows is assessed in order to judge the feasibility of a project.

The primary difference between the two methods is that payback period does not take into account the time value of money whereas NPV method accounts for time value of money.

Time value should be taken into consideration while valuing the projects because the value of $1 today is different from value of $1 in future. In an inflationary economy $1 in future will be worth less than $1 today and in a deflationary environment $1 in future will be worth more than $1 today. Hence, it is important to know what the future cashflows are worth in present value terms.

Example: Suppose a project requires an initial outlay of $100 in the year 0. The future inflows are Year 1: $30; Year : $30; Year 3: $40; Year 4: $20.

According to the payback period method the cost of investment is recovered at the end of the 3rd year. But by NPV method the future cashflows need to be discounted at an appropriate required rate of return from the project.

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