Difference Between NPV and Payback

Knowing finance and its concepts is very important. The Net Present Value and Payback are the two most commonly used financial metrics concepts when analysing and evaluating investments

Both are ways of appraising Capital Budgeting decisions that determine to make a budget in the Financial Institutions, Companies, and also Government.

NPV Vs Payback

The main difference between NPV and Payback is that the Net Present Value considers time as one dimension and money as next, while the Payback period considers money as one dimension and ignores time. Both give a snapshot of how the initial investment will be returned to us.

NPV Vs Payback

NPV stands for Net Present Value. The Net present value determines the current or present value of an investment by determining future cash flow by evaluating a series of the cost of capital.

The metric can be used for different projects, products, or any other activity which involves acquiring capital.

The payback period is defined as the time taken to recover the original investment in equipment by taking into account all the income and expenses.

It is used in capital budgeting to evaluate the profitability of potential projects. The majority of enterprise consultants, accountants, and financial managers will consider this.

Comparison Table Between NPV and Payback

Parameters of ComparisonNet Present Value (NPV)Payback
DefinitionIt is defined as the discounted total cash flow amount associated with capital investment.It is defined as the number of periods required for the initial investment to be paid back.
Treatment of interestInterest will not be reinvested but paid back to investors during the period it is earned.Here interest will be reinvested at the same rate like that, at which it was earned.
Use of Cash Flows.It includes all anticipated future cash flows, whether or not they are generated by the project under consideration.The payback method uses only those cash flows that are generated by the project itself.
PeriodThis method considers any number of periods over an indefinite future time horizon, even infinity.This method considers only cash flows occurring during a single period usually one year.
Used ForUsed for new or unproven investments or technologies because it requires estimating many uncertain cash flows.Useful for projects with limited life spans, that will be demolished at the end of their useful life. Eg. Building.

What is NPV?

NPV(Net Present Value) is a way to determine the value of a project from a financial standpoint. NPV calculations are often used to determine if a business should invest in capital or finance.

This calculation is used by accountants and financial managers to determine if a company should buy or lease equipment, or make an investment in a new venture.

Net Present Value allows us to compare projects with different profitability profiles, time horizons and used them with a project with an initial investment, to know the future cash flows.

It is the sum of all future cash receipts, minus the sum of all future cash payments, discounted back to the present at an appropriate discount rate.

If a project is worth doing because its total expected NPV is positive, it should be done. If a project is not worth doing because its total expected NPV is negative, it should not be done.

It is used as a decision-making tool when comparing projects with a different period or when putting together a business plan.

It also can be used in real estate appraisals and other areas where future income needs to be estimated and put into context with current assets.

What is Payback?

In business and finance, the payback is the amount of time required to recover the initial investment in an income-producing project.

The payback ​is a measure of the performance of a particular investment project, expressed in years.

It is calculated by the formula initial investment is divided by annual return subtracting by one. It is one of many financial measures used to compare projects or investments.

It is also known as payback time, payback period, and payback period analysis.

The Payback Period should be listed alongside the Return on Investment so that people can see what their actual payback period will be.

This can help someone make up their mind about whether or not they should buy something.
The payback period can be expressed as an annual figure or a monthly figure.

Compare interest rates and cash flow when deciding whether to invest in something. Short-term and long-term are two investment concepts.

The higher the return, the shorter the payback period, which makes it easier to recoup your costs.

If you have an opportunity to earn a high return on your investment, but you’re going to need more time to recoup your costs, think twice before accepting such high-risk opportunities.

Main Differences Between NPV and Payback

  1. The Payback period method considers the time value of money, while the Net Present Value doesn’t consider the time value of money.
  2. Net Present Value is a time value of money method, while the Payback Period is an accounting method.
  3. Net Present Value is a long-term investment decision technique for evaluating the relative merit of different investments, and the Payback method is a short-term investment technique only.
  4. The formula for Net Present Value looks more complicated than the Payback period method, but it’s much more straightforward than the latter.
  5. Payback focus on current cash flow whereas Net Present Value focuses on future cash flow.

Conclusion

While both NPV and Payback are used to evaluate investments, the two terms describe different methods for calculating total net cash flow (NCF).

Unlike Payback, NPV takes into consideration the time value of money by discounting future cash flows to the present to determine their net present value (NPV).

If lenders are trying to determine if it is more advantageous for them to fund a project or pass, a sometimes-overlooked ratio in making that determination is the Net Present Value (NPV).

Whereas the simple payback method does not account for inflation/investment assumptions, the NPV method does. Therefore, lenders should use both when determining if it would be more beneficial to invest in a project or not.

Having both of these calculations is crucial when deciding whether it’s worth investing in a project and what the return looks like.

References

  1. https://www.tandfonline.com/doi/abs/10.1080/00137919308903111
  2. https://www.diva-portal.org/smash/record.jsf?pid=diva2:831159
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