Using the Payback Method, IRR, and NPVMemo Vannario L. McCray Fin/571September 3, 2018To: Management From: Vann McCray Subject: Using the Payback Method, IRR, and NPVManagement: The topic techniques of Payback method, IRR, and NPV are tools that management utilizes with the focus on capital-budgeting determination. Regarding capital-budget choices, management always must figure out which one of these methods to use first because they make the decisions and must decide on what path needs to be taken so that the project they are embarking leads to positive results in the future. Payback MethodWith this technique, you are analyzing how much the project is costing the company versus how much revenue you can generate from the project on an annual basis. Putting this method to use will tell management the amount of time it will take to recoup what the original cost of the project will be.
This method does have its advantages and one of those would have to be that it is a lot easier to come up with calculations had NPV or IRR methods were utilized. The reason its easier is because the time value of money is ignored which can create a less than realistic results. Internal Rate of Return When management uses this technique while working on capital-budgeting they are looking to see if they make an investment would it create profits for the company.
IRR is known as a discount rate and prepares all cash flow for the NPV of any project that is compared to zero. Basically, the IRR is how much growth can be expected from a project throughout its lifespan. One downside to this method is that a lot of the questions that management would have could have more than one answer and because of this, you have the creation of a non-normal cash flow.
Net Present Value This technique is the involvement of the calculations of what cash returns may be possible when divided by the discount rate, subtracted by how much the original investment of the project was. When making a determination about a project and the NPV comes out as a positive number then management knows that the project is something worth pursuing. However, should that number be a negative one then that is a very good indicator that management should abandon any ideas of going forward with project. Unlike the numbers you may get from the payback method, these ones are a lot more reliable.
Which makes them a whole lot easier to trust when decision time comes.