Question

Create a 350-word memo to management including the following:

• Describe the use of internal rate of return (IRR), net present value (NPV), and the payback method in evaluating project cash flows.
• Describe the break-even point and its importance.
• Describe the advantages and disadvantages of each method.

Answer 1

Answer

Internal Rate of Return (IRR) is the rate of return implied in an investment or project. Mathematically, it is the discount rate at which NPV or sum of present values of all cash flows associated will become zero. This metric generates the yield expected from the investment or project but takes care of only the internal factors and not external factors like cost of capital or rate of inflation.

Net Present Value (NPV) is the measure of how much the future cash flows (net) is worth today. This is the sum of discounted values of cash flows, both positive and negative, discounted by the appropriate rate. The rate employed is called discount rate and is akin to the interest rate in calculating future value in the inverse direction. Discounting takes place at appropriate intervals as decided, like monthly, quarterly, semi annually or annually.

Pay back period is the time required to recover the cost of implementation of a project. This depends on the expected net revenues or income from the project which is compared with the initial outlay to ascertain the time period (say, number of years) required to fully recover the investment. Normally, Payback period is calculated with expected cash flows as such, without factoring the time value of money. Another approach is to discount the cash flows with the required rate of return. In that case, it is called discounted cash flow method.

Break even point is the level of a particular business variable (like quantity or price) required to recover all the costs involved. At this level, the firm reaches the optimum level of that variable so that all associated costs are recovered (no profit and no loss), provided all other factors remain constant. Costs, for this purpose, include fixed costs and variable costs. At break oven point, total cost of production equals to the revenues of that product.

Break even point is a very important tool in determining optimum level of out put required, cost of production and price of a product. This is necessary to determine capacity and level of operations required so that the firm will generate adequate revenues. If required, the business variable measured like quantity, price, etc and the product mix can be changed so as to achieve the desired results.

Advantages and disadvantages of each method:

IRR gives an overview of the likely rate of return, given the assumptions hold good. IRR of different investments or projects, as the case may be, can be compared to select one or more among them. The higher the IRR, the better. Disadvantage is that it is very much hypothetical. IRR can give real indications only if the underlying assumptions hold good. Moreover, it takes care of only the internal factors, excluding external ones like cost of capital, inflation etc.

Net Present Value is useful in deciding whether a project can be accepted. Because it throws light into the possible net gains or losses, after factoring the time value of money. However, NPV also can give real indications only if the underlying assumptions hold good. Moreover, it assumes constant rate of yield throughout the project period which need not happen in real world except in the case of investments backed by contractual obligations.

Pay back period gives an indication of how long it will take to recover the costs fully. In this case also, the true utility depends on the reasonability of underlying assumptions. The result in will be valid only if the assumptions in arriving at the anticipated cash flows like cost, price, overheads and various factors of production are realistic and occur as expected. Another drawback is that in the normal Pay back period estimation, time value of money is not factored in. In the discounted pay back method, though time value is factored, by applying discount rate, any change in the same may affect efficacy of the evaluation.

While Break even analysis is useful as discussed above, it also suffers from the limitation of dependence on reasonability of assumptions, as in the case of all evaluations. Moreover, break even analysis with respect to a particular variable (say, quantity) assumes that all other variables (like overheads, cost, price etc) will remain constant. This need not occur in the real world.