Payback period method and net present value method are capital budgeting appraisal methods used in evaluating projects. The net present value of an investment is the present value of future cash flows less the initial outlay, discounted at a firm's foregone consideration of capital. The payback period is the time required for the cash inflow from the investment project to equal the initial cash outflows.
Time Value Of Money
Net present value method considers the time value of money. Noting that the value of money is never constant, net present value method takes into account the effects of inflation, financing, risk or any other consideration that is likely to affect the future value of money. This makes it a good indicator of whether shareholder wealth is being maximised by the project. On the other hand, payback period method ignores the time value of money.
Measurement Of Cashflows
Net present value method considers the timing and magnitude of cash flows, such that future cash flows will be discounted at higher rates. This method utilises all the cash flows of a project. Payback period method only considers the timing of returns of an asset required to repay the initial cash outlay. Payback period ignores cash flows realised after the payback period.
To calculate the payback period, divide the initial investment by annual savings/revenue. As for the net present value method, calculate the expected cash inflows per year that will be obtained from the investment. Discount these cash flows at a risk-adjusted interest rate to account for time and risk. Finally, deduct the amount of the initial investment to obtain the net present value. Invest in the project with a positive net present value.
The payback period method does not always provide the best decision. Managers use it as an initial screening tool for projects. Risk-averse managers use it on the basis that the faster the recovery of the invested sums, the more attractive the investment. The net present value method provides definite decision criteria on whether to accept or reject a project. A project with a negative net present value is rejected, while the one with a positive net present value is accepted.