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NPV vs Payback Method

See Also:
Payback Period Method
Bailout Payback Method
Rule of 72

NPV vs Payback Method

NPV (Net Present Value) is calculated in terms of currency while Payback method refers to the period of time required for the return on an investment to repay the total initial investment. Payback, NPV and many other measurements form a number of solutions to evaluate project value.

Payback method, vs NPV method, has limitations for its use because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. While NPV method considers time value and it gives a direct measure of the dollar benefit on a present value basis of the project to the firm’s shareholders. NPV is the best single measure of profitability.

Payback vs NPV ignores any benefits that occur after the payback period. It also does not measure total incomes. An implicit assumption in the use of payback period is that returns to the investment continue after payback period. Payback method does not specify any required comparison to other investments or investment decision making. It indicates the maximum acceptable period for the investment. While NPV measures the total dollar value of project benefits. NPV, payback period fully considered, is the better way to compare with different investment projects. If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

NPV vs Payback method

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NPV vs Payback method

For additional information on NPV, please read Net Present Value Method.

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NPV vs IRR

See also:
Net Present Value Method
NPV Versus Payback Method
Internal Rate of Return Method
Capital Budgeting Methods
Discount Rate
Weighted Average Cost of Capital
Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

NPV vs IRR

Key differences between the most popular methods, NPV vs IRR (the Net Present Value Method and Internal Rate of Return Method), include the following:

NPV Method

Calculate NPV in terms of currency. Then express IRR in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.


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Other Variations of NPV vs IRR

Adjusted Present Value (APV)

The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields. Furthermore, it is designed for firms with active debt and a consistent market value leverage ratio.

Profitability Index (PI)

The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment. This method tends to favor smaller projects. Therefore, it is best used by firms with limited resources and high costs of capital.

Bailout Payback Method

The Bailout Payback Method is a variation of the Payback Method. Furthermore, it includes the salvage value of any equipment purchased in its calculations.

Real Options Approach

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

ROCE

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

NPV vs IRR

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