Why are NPV and IRR better than payback period?

Question

I know that payback period is the amount of time required to recover investments cost. NPV analyses the profitability of a project, while payback period ignores any profit that occurs after the payback period. I know that is also ignores time value of money. But I am not sure if I get how payback period isnt superior to NPV and IRR.

Answer 1

In some cases, payback period can be better. It is a quick calculation, and is intuitive and easily understandable. It could also be a good "tiebreaker" between two projects with similar IRR's and NPV's, or between two highly risky projects with hard-to-project cashflows.

IRR and NPV are better IN GENERAL because they simply take more factors into account, which you already described above. Besides, if your objective is to make a profit, why stop the analysis at the point of break-even? You get a more complete answer with IRR/NPV

Answer 2

Suppose that you have two possible projects that each cost one million dollars to fund.

The first project has two cash flows -- one million dollars in a year and ten dollars in two years.

The second project has one cash flow -- five million dollars in two years.

Suppose that the hurdle rate for both projects is 10%.

The first project has an IRR that is lower than the hurdle rate. It also has a negative NPV. But the payback period is one year.

The second project has an IRR that is much higher than the hurdle rate. It also has a positive NPV. But the payback period is two years.

Which project is better? Using payback period tells you to choose the unprofitable project.