Question

Why do you think the NPV and IRR models are superior to the payback period and the accounting rate of return models? Explain.

Answer 1

The NPV and IRR models are superior to the payback period and the accounting rate of return models because of time value of money.

Time value of money (TVM) is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity.

In both Payback and ARR method, the cashflows are not discounted in present value terms but they are cashflows at different point in time and thus there real worth at present times is not taken into account while calculating Payback period and accounting rate of return. But in case of Net present value method and IRR, the present value of the cashflows are taken into account while calcuating these and thus these are superior to Payback and ARR method.