“The payback rule is not the same as the NPV and is therefore conceptually wrong. With its arbitrary cut-off date and its blindness to cash flows after this date, it can lead to some foolish decisions if it is used too literally.” (Ross, Westerfield, Jordan, 1995) One of the disadvantages of payback rule is that it ignores cash flows that occur after the cut off period as opposed to NPV, which uses all the cash flows of a project. The bias towards liquidity can lead to decisions that are not in the best interest of the shareholders. Quite often a project is accepted because it recovers initial investment before the cut off date but if a NPV analysis was carried out, the NPV would be negative. Therefore, NPV approach and Payback rule can lead to conflicting decisions. Also the payback period rule does not consider the timing of the cash flows and therefore ignores the time value of money. It assigns more value to early cash flows. “The biggest drawback to the payback rule is that it does not ask the right question. The relevant issue is the impact an investment will have on the value of shares, not how long it takes to recover initial investment.” (Ross, Westerfield, Jordan, 1995) However, using the discounted payback rule can eliminate most of the disadvantages of payback rule.

The most important alternative to NPV is the internal rate of return, abbreviated IRR. IRR attempts to find a single rate of return that summarises the value of a project. The meaning of “internal” in this approach means that the rate only depends on the cash flows of a particular investment, not on rates defined by the capital market. A project is accepted if IRR is greater than the required return. Therefore accepting a project with the discount rate smaller than the IRR is equivalent to accepting a project with positive NPV. IRR of an investment is the discount rate that makes the NPV equal to zero.

IRR and NPV should lead to the same decision, nevertheless, two conditions need to be satisfied. Firstly, cash flows of a project must be conventional, meaning that the initial cash flow is negative and all the subsequent ones are positive. Secondly, the project must be independent of any other projects, which means that accepting or rejecting it will not have an influence on accepting or rejecting any other project. Problems could arise when the cash flows are not conventional. “Descarte’s rule of sign says that the maximum number of IRRs that there can be is equal to the number of times that the cash flows change sign from positive to negative and/or from negative to positive.” (Ross, Westerfield, Jordan, 1995) If the NPV of a particular project is negative at every discount rate, there will be no IRR.
The advantage of IRR over NPV is that it is easier to understand and communicate. It is difficult to estimate NPV without knowing the appropriate discount rate, whereas IRR doesn’t require the use of a capital market discount rate.

When companies are making decisions about major investments, it is probably more useful to employ either NPV rule or the Internal rate of return. For smaller projects or decisions, it may be easier and less costly to use the payback period rule. However, research suggests that there are a large number of firms using the payback rule and its popularity has been growing in the past 20 years. Study carried out by Pike and Wolf shows that out of 100 large firms in the UK 73% were using the payback rule. This number rose to 94% in 1992. One of the reasons is that firms prefer short-term projects and they need returns as soon as possible to start new projects. Also many small firms have budgets and the sooner they accumulate cash the better.