The payback period calculation looks at the shortest number of years to recover the cost of the project. Although the calculation is easy to understand and simple, it still has its limitations. It ignores the benefits that occur after the payback period and more importantly, the method ignores the time value of money. The Net Present Value is an indicator of how much value an investment or project adds to the company. The Net Present Value is a more reliable method of calculating the returns expected from investments as the method considers the time value of money.
The Net Present Value compares the value of a dollar today to the value of that same dollar in the future, taking both inflation and returns into account. A positive Net Present Value generated from a prospective project is a good sign and should be accepted. On the contrary, a negative Net Present Value resulting from projects should be rejected because the cash flows will also be negative. The Internal Rate of Return is the discount rate that delivers a Net Present Value of zero for a series of future cash flows.
As with the Net Present Value, this technique uses the discounted cash flow approach and is as widely used as the Net Present Value method. The Internal Rate of Return represents the interest yield expected from an investment and is expressed as a percentage. Moreover, the Internal Rate of Return can be found without having to estimate the cost of capital. The use of Discounted Payback Period in investment analysis is more reliable than the use of Payback Period method. This is because the former considers the time value of money by discounting the estimated cash flow at the end of each year before determining the number of years that the initial cost of the project will be recovered.
Like the Net Present Value, it considers the time value of money and as such, the outcome of using this method is more realistic and appropriate. On the other hand, the risk-adjusted discount factor produces the expected rate of return for the project, given its risk.
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