Payback period is the duration of time a project takes to recoup initial investment. The decision criterion is to accept a project with a shorter payback period.
Table 1.0 Ranks of projects using payback period.
|1||Project B||2 years 4 months|
|2||Project A||4 years|
|2||Project C||4 years|
|2||Project D||4 years|
From the above table, project B ranks first. Project A, C and D rank second. Using this approach, a project manager would choose project B. This is because it guarantees earlier returns than the other projects.
Net Present Value
Net present value measures the present value of net benefit from a project. It looks at both benefits and cost of a project. Besides, it takes into account the time value of money. A project is accepted if the net present value is positive.
Table 1.1 Net present value.
|Year||Discounting factor at 10%||Present value of Project A||Present value of Project B||Present value of Project C||Present value of Project D|
|Net present value||6,525.88||1,051.84||-5,230.33||8,630.19|
Table 1.2 Ranks of projects using net present value.
|Rank||Project||Net present Value|
Using net present value criterion, project D assures investors of a higher return than the other three projects.
Explanation of the contradicting results
The result of the payback period shows that project B is viable while that of net present value shows that project D is viable. These contradicting results emerge because of the shortcomings of the payback period. For instance, the payback period depends on the stream of cash flows. That is, it considers cash flows that occur during early life of a project and ignores those that come after the payback period. Secondly, it does not take into account the time value of money.
Discounted payback period solves the issue of time price of money. However, the discounted payback period does not take into account cash flows that come after the payback period. Therefore, it does not solve all the weaknesses of the payback period.
Decision criteria for evaluating projects
A good decision criterion for project appraisal makes use of time value of money. This is because the value of money fluctuates in response to the changing market conditions. Secondly, it should make use of cash flows generated during the entire life of a project. Finally, it should factor in the risk of a project. Risk premium is often added to rate of return to cater for risk. Net present value technique takes into account all these elements. Therefore, it qualifies for a good tool of project appraisal. Payback period does not meet any of the three criteria.
Internal rate of return and net present value
Net present value measures the deviation of cash outflow from cash inflow. Internal rate of return shows the break-even point of an investment. This is the point where the net present value is zero, that is, the point where the difference between cash inflow and cash outflow is zero. A market is efficient when it clears that is when it is at equilibrium. Equilibrium point in a market is the point where the total costs equal to total revenue. This is the same as the break-even point.