Net Present Value Payback Period Internal Rate of Return

The Internal Rate of return (IRR) is the rate at which the NPV is equal to 0.This rate can be determined by interpolating between two rates, one of which has a positive NPV and the other a negative NPV.
Various financial metrics are used to evaluate the feasibility of a project. Some of the popular metrics in use include the Payback Period, the Net Present Value (NPV) and the Internal Rate of Return (IRR).
The payback period is one of the simplest methods for assessing the feasibility of a project and can be calculated quickly. The Payback period is the number of years it takes to recover the investment made in a project and is calculated by interpolating between the two consecutive years when the cumulative cash flows from the project are respectively below and above the investment made. Suppose an investment of 100,000 results in cash flows of 20,000, 30,000, 40,000 and 50,000 in four years. The cumulative cash flows are 20,000, 50,000, 90,000 and 140,000. It is clear that the investment of 100,000 is recovered in the fourth year. The actual figure of the payback period is calculated by interpolation between the last two figures.
The disadvantage of the payback period is that it fails to take into account the time value of money. Time value of money arises from the fact that cash received at an earlier point in time is more valuable than the same amount of cash received at a later point in time. If one were to invest the amount of $10,000 received today at an interest rate of 10%, that person would receive $11,000 after one year. Thus receiving $10,000 today is worth more than receiving $10,000 after one year.
The second disadvantage with the Payback method is that it ignores the cash flows that accrue after the payback period is over. If the payback for Project A is 3 years and that for Project B is 5 years, using the payback method one would conclude that Project A is better. However, this need not be so. Suppose Project A has a total life of 5 years and generates 120% of the investment during the entire life of the project, while Project B has a 15-year life and generates 200% of the investment in this period, it is apparent that Project B is better although it has a longer payback period.&nbsp.