25.5 Compare and Contrast Non-Time-Value-Based Methods and Time-Value-Based Methods

Non-Time-Value-Based Methods

1. Payback Period

   • Focus: Liquidity
   • Pros: Simple, highlights risk
   • Cons: Ignores time value and cash flows after payback

2. Discounted Payback Period (hybrid)

   • Accounts for time value but still ignores post-payback cash flows

3. Accounting Rate of Return (ARR)

   • Focus: Accounting profitability
   • Pros: Uses familiar accounting data
   • Cons: Ignores time value, uses accounting profit not cash flow

Time-Value-Based Methods

1. Net Present Value (NPV)

   • Focus: Value creation
   • Pros: Considers time value, cash flows, risk
   • Cons: Requires accurate discount rate

2. Internal Rate of Return (IRR)

   • Focus: Rate of return
   • Pros: Intuitive, considers time value
   • Cons: Multiple IRRs possible, reinvestment assumption

3. Profitability Index (PI)

   • Focus: Value per unit of investment
   • Pros: Useful for capital rationing
   • Cons: May conflict with NPV when comparing mutually exclusive projects

4. Discounted Payback

   • Focus: Liquidity with time value
   • Pros: Considers risk and time value
   • Cons: Ignores cash flows after payback

Comparison Table

Method	Time Value	Cash Flow Focus	Decision Metric	Best Use
Payback	No	Cash inflows	Years to recover	Quick risk assessment
Discounted Payback	Yes	Cash inflows	Years to recover (discounted)	Liquidity with risk
ARR	No	Accounting profit	Percentage return	Simple performance measure
NPV	Yes	Cash flows	Monetary value	Primary decision metric
IRR	Yes	Cash flows	Rate of return	Supplement to NPV
PI	Yes	Cash flows	Ratio (benefit/cost)	Capital rationing

Decision Framework

• Use payback/ARR for quick screening
• Use NPV/IRR/PI for final decisions
• Use discounted payback to assess risk/liquidity
• Consider qualitative factors throughout

Luxembourg Compliance Note

In Luxembourg, SMEs often start with simple methods (payback, ARR) but banks and investors will expect NPV and IRR analysis for financing decisions. Capital budgeting analysis should also include sensitivity and scenario testing given market volatility.

Think It Through

Can a project have a positive NPV but fail the payback test? Should it be accepted? Why or why not?

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