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Capital Budgeting: NPV, PI, IRR, Payback

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How do the capital budgeting systems of NPV, PI, IRR, and Payback compare with each other? How is each employed in capital budgeting decisions?

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Strengths and weaknesses

Payback differs from NPV, PI and IRR because it does not consider the time value of money. In fact, it only looks to see how quickly the investment is repaid by returns. This is a very conservative approach and so limits risk. Its weakness is that it disregards the cost of capital (time value of money).

NPV and PI analyze the present value of future cash flows and returns either a dollar amount (NPV) or a ratio (PI) giving a clear decision result (positive $ or over 1 for PI). This is easy to absorb and translates into cash flow that is the major outcome desired. It uses time value to discount flows that are far off and so advantages near returns. It is hard to compute so you need a spreadsheet and not everyone understands all the ingredients.

IRR is an annualized rate of return that can be quickly compared to ...

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  • MSc, University of Virginia
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