i. Payback period:
The advantage of the payback period:
To some degree, we can say that the shorter the payback period, the less risk the investment is. So the measurement of the payback period takes into account of the risk of the investment. In addition, with the shorter payback period, you can recover your initial investment and can use your money to invest on other new projects. So it can help the company seek profitable investment opportunities in the changing market.
The disadvantages of the payback period:
It does not take into account of the time value of the money. It gives the equal weight to all the cash flow occurred in different time. With a greater inflation, the payback period may bring companies great loss.
The factor of the investment size is not included in the payback period. Even though a project has a short payback period, it may have a very small profit. In contrast, another project, with a big investment size and a relatively long payback period, is very profitable. The payback period does not give attention to the term structure. With the same payback period, two different projects may have dramatic lad in profitability.
When to use payback period:
According what mentioned above, it is better use payback period to make investment decisions when all the projects have no difference on other items and when the investor gives much importance to the recovery time.
ii. The analysis of the IRR:
The merit of this measurement is taking into account of the time value of the money and the term structure of the cash flow. It has strong links with NPV. We can easily see this correlation from its definition. NPV is an absolute value, but IRR is a relative value. So it can better reflect the efficiency of the...