Explain how payback period NPV and IRR criteria are used in

Explain how payback period, NPV, and IRR criteria are used in decision making.

Solution

Decision making is the process of determining whether or not an investment is worthwhile. Often companies will have several opportunities and must measure each one\'s potential in order to make a comparison and choose just one or a few. For example, a company might be trying to determine whether to buy new equipment to expand production capacity on an existing product, or to invest in research and development for a new product. The three main methods of taking this measurement are Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period.

IRR

Internal Rate of Return is a percentage very similar to an interest rate, and is used to compare a capital investment against other kinds of investment. Divide the expected profit by the expected expenditure, and you\'ll arrive at a percentage of returns. Then look at the company\'s other projects and determine the minimum acceptable percentage of return; this is called the hurdle rate. If the IRR is higher than the hurdle rate, the project is worth pursuing. The IRR is easy to understand, and is thus the most commonly used technique, though the NPV is more accurate.

NPV

Net Present Value, or NPV, combines two concepts of value. First, it determines how much cash will flow in as a result of the investment, and compares that against the cash that will flow out in order to make the investment. Since these flows take place over time, and often the investment will pay off much later, we also take into account the present and future value of money. Because of inflation, money earned in the future is worth less in today\'s dollars than the same amount would be today. Therefore, NPV calculates all of those inflows and outflows over time, takes inflation and foreign exchange rates into account, and expresses the final benefit to the company in terms of today\'s dollars.

Payback Period

Very simply, the payback period tells you how long it will take to recover your investment in a project. If it will take one year to make back the investment from revenues from a new product, the payback period is 1. The payback period method is antiquated and falling into disuse, because it has some significant drawbacks. It doesn\'t take into account the time value of money, and it tends to favor very cyclical products that make the bulk of their money up front, rather than those that build momentum and can produce cash inflows over a long period.