Introduction
A firm's resources are scarce compared to the uses to which they can be put. Thus, a firm needs to choose where to invest these resources to earn the highest possible return for its investors. Thus, the investment decision relates to how the firm's funds are invested in different assets. An investment decision can be long-term or short-term. A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long-term basis. Net Present Value and Payback are two of the most used financial metrics concepts when analyzing and evaluating investments. Both the methods are ways of appraising capital budgeting decisions that determine to make a budget in the Financial Institutions, Companies, and governments. NPV is the short form for Net Present Value. It determines the current or present value of an investment by selecting future cash flow by evaluating a series of the cost of the capital. This metric can be used for different projects, products, or any other activity which involves acquiring capital. The payback period is known as the amount of time required/taken to recover the original investment in equipment by considering all the income generated and expenses incurred. It is used in capital budgeting decisions to evaluate the profitability of potential projects. Most enterprise consultants, accountants, and financial managers will consider this.
Net Present Value vs Payback
The main difference between Net present value and Payback is that the former considers time as one dimension and money as the other. In comparison, the Payback period considers money as one dimension and ignores time. Both give a gist of how the initial investment will be returned to us. Interest will not be reinvested. It will be paid back to investors during the period it is earned in net present value. However, in Payback, interest will be reinvested at the same rate as that at which it was acquired. Net present value includes all anticipated future cash flows, whether they are generated by the project concerned. The payback method uses only cash flows generated by the project itself. Net present value considers any number of periods over an indefinite future time horizon, even infinity, while Payback considers only cash flows occurring during a single period, usually one year. Net present value is used for new or unproven investments or technologies because it requires estimating many uncertain cash flows, whereas Payback is used for projects with limited life spans, i.e., they will be demolished at the end of their useful life.
Difference Between Net Present Value and Payback in Tabular Form
| Parameters of Comparison | Net Present Value | Payback |
| Definition | Net present value is defined as the difference between the current value of cash inflows and cash outflows over a period. | The payback period is known as the amount of time it takes to recover the cost of an investment. It is the length of time an asset reaches a breakeven point. |
| Interest treatment | Interest will not be reinvested. It will be paid back to investors during the period it is earned. | Interest will be reinvested at the same rate at which it was earned. |
| Utilization of cash flows | Net present value includes all anticipated future cash flows, whether they are generated by the project under consideration. | The payback method uses only those cash flows that are generated by the project itself. |
| Period | Net present value considers any number of periods over an indefinite future time horizon, even infinity. | Payback considers only cash flows occurring during a single period, usually one year. |
| Used for | Net present value is used for new or unproven investments or technologies because it requires estimating many uncertain cash flows. | Payback is used for projects with limited life spans that will be demolished at the end of their useful life. |
What is Net Present Value?
Net present value is known as the difference between the current value of cash inflows and outflows over a period of time. Interest will not be reinvested. It will be paid back to investors during the period it is earned. It includes all anticipated future cash flows, whether they are generated by the project under consideration. Net present value considers any number of periods over an indefinite future time horizon, even infinity. Net present value is used for new or unproven investments or technologies because it requires estimating many uncertain cash flows.
The formula of Net Present Value:
n
∑​ Rt/(1+i)^t​​
t=1
Full forms:
Rt =Net cash inflow minus the outflows during a single period of t
i=Discount rate of return that may be earned by investing
alternative/different investments
t=Number of timer periods
(or)
Net present value = today's value of the expected cash flows - Today’s value of invested cash
Positive and Negative Net present values
A positive net present value often indicates that the future estimated earnings generated by a project or investment exceed the anticipated costs. It is generally assumed that an investment with a positive Net present value will be profitable. An investment with a negative Net present value will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive Net present value values should be considered.
Limitations of using Net Present Value
Gauging an investment's profitability with NPV relies heavily on assumptions and estimates, so there can be substantial room for error. Estimated factors include investment costs, discount rate, and projected returns. A project may often require unanticipated expenditures to get off the ground or may require additional spending at the project's end.
How to know whether the Net present value is reasonable?
A Net present value is “good” if it is greater than zero. The NPV calculation already takes into account factors such as the investor’s cost of capital, opportunity cost, and risk tolerance through the discount rate. And the future cash flows of the project, together with the time value of money, are also captured.
What is Payback?
The payback period is known as the amount of time it takes to recover the cost of an investment. It is the length of time an asset reaches a breakeven point. Interest will be reinvested at the same rate at which it was earned. This method uses only those cash flows that are generated by the project itself. It considers only cash flows occurring during a single period, usually one year. It is used for projects with limited life spans that will be demolished at the end of their useful life.
Computation of Payback
Payback Period = Initial Investment /Annual Cash Flow
Limitations of using the payback period method
As rightly shown in the equation, the payback period calculation is simple. It does consider the repercussions of inflation or the time value of money. Neither does it account for the complexity of investments that may have unequal cash flow over a period of time. The discounted payback period is generally used to give a better account for some of the shortcomings, like using the current value of potential cash flows. Thus, the simple payback period may be favourable, while the discounted payback period might indicate an unfavourable investment.
Unlike other methods of long-term investment decisions, the payback period always ignores the time value of money. This is the idea that money's worth is more today than the same amount in the future as the earning potential of the present amount of money. Most capital budgeting formulas, like net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the time value of money. Thus, if a company pays an investor, it should include an opportunity cost of the investment. The time value of money assigns a value to the opportunity cost involved. The payback period disregards the concept of the time value of money. It is determined by counting the number of years it takes to recover the funds invested. Thus, it ignores the overall profitability of an investment. Many managers and investors, therefore, prefer to use net present value as a tool for making investment decisions.
Example: The payback period is five years if it takes five years to recover the cost of an investment. It does not account for what happens after Payback occurs.
How to know whether a payback period is reasonable?
The best payback period is generally the shortest payback period that is possible. Getting repaid/recovering the initial cost of a project/investment should be achieved as quickly as possible. Although, not all investments have the same time horizon. Thus, the shortest possible payback period needs to be nested within the larger context of that time horizon.
When is the payback period utilized for capital budgeting (long-term investment) decisions?
The payback period is favoured when a corporation is under liquidity constraints as it can show how long it would approximately take to recover the money laid out for the project. If short-term cash flows are an issue, a short payback period may be more attractive than a longer-term investment that has a higher Net present value.
What is the difference between the payback period and break even point of an investment?
Although the two terms are related, they are not the same. The breakeven point is the value that an investment must rise to cover the initial costs. The payback period is known as the amount of time that it takes to reach the breakeven point.
Main Differences Between Net Present Value and Payback In Points
- Net present value refers to the difference between the current value of cash inflows and outflows over a period, while the payback period refers to the amount of time it takes to recover the cost of an investment. It is the length of time an asset reaches a breakeven point.
- Interest will not be reinvested in the net present value method. It will be paid back to investors during the period it is earned; however, in the payback period method, interest will be reinvested at the same rate at which it was acquired.
- Net present value includes all anticipated future cash flows, whether they are generated by the project under consideration, whereas the payback method uses only those cash flows that are generated by the project itself.
- Net present value considers any number of periods over an indefinite future time horizon, even infinity, while Payback considers only cash flows occurring during a single period, usually one year.
- Net present value is used for new or unproven investments or technologies because it requires estimating many uncertain cash flows. However, Payback is used for projects with limited life spans that will be demolished at the end of their useful life.
Conclusion
It is essential for a firm to choose where to invest these resources so that they can earn the highest possible return for their investors. A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long-term basis. The Net Present Value and Payback are two of the most used financial metrics concepts when analyzing and evaluating investments. The net present value determines the current value of an asset by determining future cash flow by considering a series of the costs of the capital. This metric can be used for various products, projects or any other activity that involves acquiring capital. The payback period is known as the amount of time taken to recover the original investment by considering all the income generated from it and expenses incurred on it. It is used to determine capital budgeting decisions to evaluate the profitability of potential projects. Most enterprise consultants, accountants, and financial managers will consider this. This article has attempted to explain the critical differences between Net present value and Payback. It has also described the concept of Net present value in detail, its computation, and its limitations. Further, it has demonstrated positive and negative net present values and has also explained how to identify a good net present value. It has shown the concept of a payback period in detail, covering its computation, limitations, how to determine a reasonable payback period and when a payback period is utilized for capital budgeting (long-term) investments.
