Using the Payback Method, IRR, and NPV example

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Using the Payback Method, IRR, and NPV

The payback method (PB), Internal Rate of Return (IRR), and the Net Present Value (NPV) are investment appraisal techniques. The use of each method in assessing project feasibility has advantages and disadvantages for investors.
Project managers commonly use the payback method in evaluating project cash flows. The method evaluates the project by measuring the period it takes to recover the initial investment (Gorshkov, Rymkevich, Nemova, & Vatin, 2014). As a tool for evaluating project cash flows, payback method is always used by project managers as it is easy to apply and understand irrespective of academic background or field of expertise.

However, payback method ignores cash flows beyond the payback period. Therefore, it assumes long-term profitability of a project. Managers also use NPV calculations to assess project cash flow. According to Damodaran (2012), NPV method identifies the present value of the project's foreseen future returns. NPV is computed by subtracting the present value of the project's cost from the present value of future income
(Damodaran, 2012). The principle benefit of using this method is that it considers when the project will earn income. On the other hand, its limitation is that it requires managers to make projections. In other
words, managers must approximate the project's cost and its future returns.

IRR method evaluates the attractiveness of a project or cash flow. Percoco and Borgonovo (2012) describe this method as the interest rate at which the net present value of the cash flows of an investment equal zero.
If the IRR of a new project surpasses the required rate of return, then the project is desirable. Mostly, project managers prefer IRR method as it offers a quick snapshot of projects that would give the highest possible
cash flow. However, this approach only focuses on projected cash flows that come from capital investment. As a result, it ignores the potential future costs that eventually affect returns.

Payback period, NPV, and IRR are all essential project evaluation techniques, but project managers should consider the limitations of each method when choosing which one to implement.

Gorshkov, A. S., Rymkevich, P. P., Nemova, D. V., & Vatin, N. I. (2014). Method of calculating the payback period of investment for renovation of building facades. Stroitel'stvo Unikal'nyh Zdanij i Sooruzenij, (2), 82.
Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons.
Percoco, M., & Borgonovo, E. (2012). A note on the sensitivity analysis of the internal rate of return. International Journal of Production Economics, 135(1), …

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