Merits and Limitations of Payback Period and Net Present Value (NPV)

Payback period

According to Atrill and Maclaney (2019) the most significant merit of this method is that it is both simple to apply and comprehend. This is because it needs few inputs and as such easier to calculate. This view is echoed by Drury (2015) who recognises that despite the fact that other methods use similar inputs, they demand more assumptions than payback method. In addition, due to fewer inputs, the method aids in quick decision making which is very critical especially for firms with limited finances. Further on, for small firms with limited resources, the method helps them by preferring projects with shorter payback period which are less risky and aids to recover invested funds much faster. However, this method has some limitations. To start with, Darmodaran (2015) advance that its main limitation is that it ignores the time value of money which in turn distorts cash flows true value. In addition, the method may tempt a firm to overlook a project that potentially could generate more cash flows in later years as it fails to take them into account. Similarly, a project with longer Payback period may be more profitable than one with the shorter one.

Net present value (NPV)

Klara (2016) confirms that the most noteworthy advantage of this method is its consideration of the time value of money. The method takes into consideration investments discounted cash flows so as to assess its viability. In addition, unlike the payback period, which ignores cash flows after the payback period, NPV account for all cash flows the management defines (Pasada, 2017). However, just like other appraisal methods, NPV has some shortcoming. Firstly, Barry et al., (2015) note that the main disadvantage of this method is that guessing about future cash flows is needed which makes it prone to error. Secondly, the method is not applicable for projects with different amounts of investments. Similarly, the method is problematic to use when assessing projects with differing life spans.