Question

What are your thoughts on why payback and IRR are more frequently used than NPV, when evaluating projects?

Which method does your organization prefer?

Answer 1

i will combine the answer to both the questions asked here. Let me start by saying that generally and most of the time NPV method is preferred over payback or IRR method. There are multiple reasons for that :

1. Payback method does not include future cash flow once you have recovered the cost. So if payback is 3 years, cash flow after year 3 will not be looked at

2. Simple Payback does not take into account the time value of money. For that you need to calculate discounted payback

3. Although IRR is relatively simpler method than NPV, but there are problems with IRR. if there is non conventional cash flow pattern and multiple outflows during the project term, there will be problem of multiple IRR.

4. IRR method compare discount rate with IRR to choose project. But if the project is of longer duration and discount rate will not remain same through out the term of the project.

So in nutshell I would prefer NPV method and i disagree with the question saying IRR and payback is used more frequently than NPV.

LET ME KNOW IF YOU HAVE ANY DOUBTS