Question

Contrast the differences between Payback Period, Net Present Value, and Internal Rate

of Return in the evaluation of projects. For each method, you should describe how the

method works, the decision rule when using this method in evaluating an investment,

and one (1) drawback of this method.

Answer 1

Their are various methods for the evaluation of the given Project. For any project, we have the initial outflow and the expect cash inflows for a certain period for which the Project shall Operate. When we come to the statistical decision making whether or not to accept any given project we see if the net proceeds from the project will be negative or Positive.

                In lay man language, the cash flows are provided as a Value which will be obtained at a Future date in form of Inflows from the given project. In order to make a decision today, we compute the Present values (PV) of the proposed Future Inflows and compare the total of PV of all the future Inflows with the PV of all the Outflows from the given Project.

Some of the methods used to ascertain the acceptability of the Project are as follow:-

1. Pay Back Period
2. Net Present Value
3. Internal Rate of Return

The differences in each of the above methods is as given below:-

Feature	Pay Back Period (PBP)	Net Present Value (NPV)	Internal Rate of Return (IRR)
Formula	= PV of Future Cash Inflows     Expected Initial Outflow	= PV of Future Cash Inflows    (-) Expected Initial Outflow	= PV of Future Cash Inflows    (-) Expected Initial Outflow
Discounting Rate	Market Rate of Return /Cost of Capital	Market Rate of Return /Cost of Capital	Internal Rate of Return
How it Works	This method gives a time period in which the Amount Initially Invested is totally recovered. Which means, at the PBP the Initial Outflow will be equal to the PV of Future Cash Inflows	It gives the Net Value of the PV of Future Inflows minus the PV of Cash outflows of a given Project. A Negative value indicates that the Net Inflows will be less than the Cash Out Flows and hence the Project should not be accepted	This is mostly like the NPV method, only the difference being that the Cash flows are discounted at the IRR. IRR being a rate that gives the PV of Future Cash Inflows equal to the PV of Cash Outflows.
Decision Rule	If the PBP is less than the total period of the project, then the Project may be accepted. If the PBP is more than the duration of the Project, then the project should not be accepted. The Project with shortest PBP should be accepted.	If the NPV presents a Positive Value, the given Project may be accepted. If the NPV presents a Negative Value then the Project shall not be accepted.	The IRR rule states that if the internal rate of return on a project or investment is greater than the minimum required rate of return, typically the cost of capital, then the project or investment should be pursued.
Drawback	It neglects the Project’s Return on Investment.	The CoC rate used for discounting is usually guessed. It becomes difficult to arrive at a Coc if the firm uses various Sources of Finance.	The IRR method does not consider important factors like project duration, future costs, or the size of a project