Key differences between the most popular methods, the NPV Method and IRR Method, include: * NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; * Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; * The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); * However, the IRR Method does have one significant advantage – managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, * While both the NPV Method and the IRR Method are both discounted cash flow models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash. * Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation. (Wilkinson 2013)
It makes this adjustment using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital -- either interest paid on borrowed money or interest not earned on money spent to pursue the project (Opportunity cost).
Under the payback period method, a company estimates how much it will cost to launch the project and how much money the project will generate once it's up and running. It then calculates how long it will take the project to "break even," or generate enough money to cover the startup costs.