Question

difference between payback period and accounting rate of return and NPV and IRR

Answer 1

Difference between payback period and accounting rate of return:

Payback period is one of the simplest methods used for evaluating capital expenditure decisions. As name suggest, it tells about the period during which the cost of project will be recovered.

It is calculated as follows :

= Initial cash outflow / annual cash inflow

It is expressed in number of years.

But this method in itself is not fully capable for the decision making of any investment. Few negatives about this method include - time value of money is not included, some projects will have quicker cash flows initially and may end up generating lower cash flows after the payback period and so on.

Accounting rate of return:

The main focus of accounting rate of return is on accounting income and not cash flows ( which is used in payback period calculation). It takes into account the increase in net income and is the accounting technique of  evaluating the profitability of investment options. It is calculated as follows :

= (average annual profit after tax/average investment)*100

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Difference between NPV and IRR

NPV discounts the future expected cash flows to current value. This will give us cash surplus or loss for the investment done. NPV gives us a dollar value that the investment will generate.

IRR generates the percentage return on investment done. It calculates the percentage rate of return at which the NPV of cash flows is zero. It arrives at the breakeven cash flow level of a project.

NPV is used in decision making of an investment to be done as it gives the dollar value where as IRR is not used in decision making as it doesn't calculate the cash flows which a project will generate.

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