NPV vs IRR vs Payback: Capital Budgeting Made Simple
By SimplyCPA · 24 October 2026
On this page (5)
- NPV: Present value of cash inflows minus the investment, at the required rate of return. Accept if NPV is positive.
- IRR: The discount rate that makes NPV zero. Accept if IRR exceeds the required rate.
- Payback: How long it takes to recover the investment in undiscounted cash — simple, but ignores the time value of money and later cash flows.
- Profitability index: PV of inflows ÷ investment; useful for ranking projects when capital is limited.
- When they conflict: For mutually exclusive projects, NPV is the better guide.
The question capital budgeting answers
Should a company spend money now to receive cash later? Because money has a time value, cash flows years apart can't simply be added up — they have to be discounted at the company's required rate of return (often its cost of capital).
One project, four measures
A project costs $10,000 today and returns $4,500 at the end of each of the next 3 years. Required rate of return: 10% (3-year ordinary annuity factor at 10% = 2.48685).
- Net present value (NPV) — PV of inflows = $4,500 × 2.48685 = $11,190.83. NPV = $11,190.83 − $10,000 = $1,190.83. Positive, so the project earns more than 10%.
- Internal rate of return (IRR) — the rate at which NPV is zero, i.e. where the annuity factor equals $10,000 ÷ $4,500 = 2.2222. That's between 16% (2.2459) and 17% (2.2096): about 16.7%. It exceeds 10%, so accept.
- Payback period — $4,500 + $4,500 = $9,000 after 2 years; the remaining $1,000 takes $1,000 ÷ $4,500 = 0.22 of year 3. Payback ≈ 2.22 years.
- Profitability index (PI) — $11,190.83 ÷ $10,000 = 1.12. Above 1 means a positive NPV.
Strengths and weaknesses
| Method | Strength | Weakness |
|---|---|---|
| NPV | Measures the value added in dollars; uses all cash flows and the time value of money | Needs a required rate; harder to explain than a percentage |
| IRR | An intuitive percentage return | Assumes cash is reinvested at the IRR; can give multiple answers when cash flows change sign more than once; can rank projects wrongly |
| Payback | Simple; a rough measure of liquidity risk | Ignores the time value of money (unless discounted payback is used) and anything after the payback date |
| PI | Ranks projects when capital is rationed | Like IRR, a ratio can favour small projects |
NPV assumes cash flows are reinvested at the required rate, which is usually more realistic than the IRR's assumption. That's why, when two mutually exclusive projects rank differently under NPV and IRR, NPV is preferred.
Practice MCQs
1. A project's IRR is 12% and the company's required rate of return is 14%. Its NPV at 14% is:
(A) Positive (B) Zero (C) Negative (D) Impossible to tell
Answer: C. Discounting at a rate above the IRR gives a negative NPV.
2. Which method ignores cash flows that arrive after the investment has been recovered?
(A) NPV (B) IRR (C) Payback (D) Profitability index
Answer: C.
Related BAR coverage: financial forecasting and projections and our time value of money explainer.