Payback Period and Net Present Value Method
The two major methods used for capital budgeting are payback period and net present value (NPV) method. Payback period focuses on the length of time required to recover the original investment made when acquiring an asset while the net present value is a technique used to compare the present value of potential investments to the amount of the initial investment. The difference between the two methods is significant due to the different ways they measure the success of an investment project.
Payback period is the number of accounting periods required to recover the original cost of investment. The calculation of the payback period will not take into account the time value of money, but instead takes the cumulative cash inflows during the expected life of the project, deducts the original cash outflow and then calculates the number of accounting periods for the project to recover the original investment. A project’s payback period can either be determined by calculating the average annual cash flows from the project or by adding the annual cash flows until the total accumulated cash flows equals the original outflow. Advantages of the payback period include its simplicity and ability to answer the question “how long will it take to recover my money”. The limitation of the payback period is that it greatly ignores the time value of money aspect and does not consider future cash flows after the payback period is met. For example, a company may not realize the full potential of its investment since it may only analyze the cash flows that are larger than the initial investment, omitting the future cash flows of the project.
Net present value on the other hand takes into account the time value of money and potentially utilizes all of the future cash flows generated by the project. The time value of money is a major concept in finance that states that, given a certain rate of return, a dollar today is worth more than a dollar in the future due to its potential earning capacity. The net present value technique can compare two or more potential investments and determine which investment would realize the greatest satisfied rate of return. To calculate the net present value, we first need to calculate the expected cash flow for each period. Secondly, these cash flows need to be discounted at the appropriate discount rate to reflect the time value of money. Finally, the net present value would be calculated by subtracting the discounted cash flows (present value) to the initial capital outflow. The advantages of using the net present value method to analyze potential projects is its ability to consider the effect of the time value of money and its potential to generate higher returns. The major limitation of the net present value method is its overly reliance on assumptions and estimates which can lead to inaccuracies.
In conclusion, the payback period and net present value method are two major approaches used in capital budgeting. Although both methods focus on determining the financial viability of a project, the differences between the two methods are significant due to their differing approaches. The payback period does not take into account the effect of the time value of money and does not consider future cash flows after the payback period is reached. The net present value method however, does consider the effects of the time value of money and may generate higher returns if the assumptions upon which they are based are correctly calculated.
