Memo
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From:
Date:
Subject: Uses, Advantages, and Disadvantages of Payback, IRR, and NPV Methods.
The internal rate of return denoted as IRR is a technique used in capital budgeting to assess the productivity of prospective investments. IRR used to rank numerous prospective projects. A project is more desirable to undertake if its IRR value is higher. One of the advantages the technique is that it considers time value money in evaluating the investments (Garcia, 2017). Secondly, IRR is simple to interpret once it is calculated. However, this method does not prove to be fruitful in some circumstances since it ignores the actual dollar value of benefits. An individual ought to always consider a project value of $100,000 with a 20% rate of return over a project of $1,000 with a return rate of 50%. It is apparent that the dollar value of the first project ($10,000) is higher than the second project ($500). The techniques also don’t account for reinvestment and also neglects future cost in its formula (Garcia, 2017).
The net present value denoted as NPV refers to the difference between the present values (PVs) of cash flows over a specified period. This technique is used to evaluate the productivity of a venture. This concept dictates that projects or investments with NPV values that are positive to be considered first. The NPV method is advantageous since it is founded on the notion that the amount of cash received in the future worth less than the same amount today. NPV also indicates the value created by the project. However, the technique requires guessing regarding the estimation of the firm’s cost of capital and also the future cash flows (Drake, N.d). The method is also not suitable when comparing investments that have differing amounts of investments.
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The payback period is used to assess the length of time required for the income from the project to pay the initial investment (Maverick, 2018). It used to determine whether to undertake a project, as shorter payback periods are more desirable. The advantages of this method are that it is simple and allows for the comparison of numerous projects. Projects with shorter payback period are considered first. However, this method ignores time value money, and this makes it disadvantageous (Maverick, 2018). Other disadvantages are that it does not take into account cash flows received after payback, doesn’t consider a project’s return on investment, and also ignores the profitability of a project.
References
Drake, P. (N.d). Advantage and Disadvantages of the Different Capital Budgeting Techniques. [Online]. Available at: http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf . Accessed 20th Jan 2019.
Garcia, M. (2017). The Advantages and Disadvantages of the Internal Rate of Return Method. [Online]. Available at: https://bizfluent.com/info-8564382-advantages-internal-rate-return-method.html . Accessed 20th Jan 2019.
Maverick, J. (2018). What are Some Limitations of Using a Payback Period for Analysis? [Online]. Available at: https://www.investopedia.com/ask/answers/062915/what-are-some-limitations-and-drawbacks-using-payback-period-analysis.asp . Accessed 20th Jan 2019.
