Question

There are various investment decision rules, which financial managers may select. Choose one of the alternatives to the NPV, and compare and contrast one of the selected alternatives with NPV (payback period, discounted payback period, IRR or profitability index.

Answer 1

NPV:

Present value of cashoutflow-Present value of cashinflows ------discounted at suitable discount rate

Payback period:

Payback period is used for calculating the amount of time it is required to get back the initial invested amount. ie: it calculate the time period by which a project reaches its break even point. Shorter payback period is more attractive and longer payback period means projects are a red flag.

Payback period= (p - n)÷p + nx

where p=cashflow at which first cumulative value occurs ; n=cumulative cashflow at last negative value of cumulative cashflow occurs ; nx=no of years in which last negative value of cumulative cashflow occurs.

eg:

Years	0	1	2	3	4
Investment	-100000
Cashflows		20000	50000	30000	10000

From the table the payback period= 3 years ; ie in 3 years the initial investment of 100000 will be recovered by the project.

Comparison:

Comparing to npv which is the net present value which is the difference between present value of cash inflows and present value of cash outflows;

• The payback period method doesnt consider the time value of the cashinflows. unlike npv
• The payback method fails to consider cash inflows after the payback year. ie; as in the example the value of the cashflow in year 4(10000) is not accounted for in payback period. Whereas npv rule consider all the possible cashflows.
• One of the similarity between both the method is npv and payback period assess a project in terms of financial terms which ignores the future potential to its investment .