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Subject: Evaluating Projects
What are your thoughts on why payback and IRR are more frequently used than NPV, when evaluating projects?
I think the payback method of capital budgeting is used because of it’s simplicity. It is easy to understand and provides a quick review of how long a project will return the initial investment. The downside is that it does not account for the time value of money and also doesn’t count future cash flow after the initial investment is returned. Using Internal rate of return accounts for both of these and is also simple to understand. Another benefit is it provides a person with a comparable number when measuring the return from two or more different projects.
Net present value, in my opinion, is tough to understand. It seems backwards when trying to determine the value of a capital investment in a project. It is also difficult to calculate because assumptions have to be made on future cash flows. The number is also not relative when comparing two different projects. An NPV of $200k on two projects can mean two different things if the first one has an initial outlay of $500k and the other $1mm. In contrast, two investments with the same IRR, let’s say 12%, both have the same rate of return.
Required:
What are your thoughts on why payback and IRR are more frequently used than NPV, when evaluating projects? Write 200words.
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