Brittany
Hello Brittany. I agree with you that when the ash flows in one direction, inwards, less time will be taken to recover the investment costs. The project will have gained from the investment. The profitability index will thus be more than 1. A positive NPV means that the cash flowing inwards has a greater value than the costs incurred in investing. The Internal Rate of Return will be higher than the base value because of the positive NPV.
In the calculation of the payback period, the initial investment is divided by the net cash flow per period as you have pointed. The problems of the payback period are: it ignores the value of money in relation to time, and it leans on the short-term projects only. The advantages are: it is simple to analyze, and it is in favor of liquidity of projects that take a short period of time. I find your response informative. Thanks.
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Santanas
Hello Santanas, I concur with you that when the cash flows conventionally (in one direction, inwardly), the payback period will be shorter than the project's life. The payback period is calculated by dividing the investment by cash flow as you have indicated. But two methods can be used depending on the nature of the cash flow. When the cash flow is uniform in all the years, you use the method you mentioned, but when it is not uniform, you cumulate it up to the time when the cash flow and the initial investment outlays are equal.
The payback period shows the time a project will take to return the investment that was used to run the project. Another disadvantage of Payback period is that it ignores the time value of money. You calculate the profitability index by dividing the cash flow’s value by the value of the cash that was invested as the project began. Thank you.
