Question

If we accept that the goal of the financial manager is to create value for the stockholder, it follows that the financial manager must have a means of evaluating a prospective investment in terms of its likelihood of enhancing shareholder value. Different decision criteria may be used to evaluate proposed investments and we have gone through a pretty thorough review of most of them (NPV, IRR, Payback Period (straight and discounted), AAR, MIRR, PI). Our review included learning how to calculate each one as well as come to an understanding of the advantages and disadvantages of each. “Conventional wisdom” tells us that only the NPV criterion can always tell us if a particular project is a good investment and, if we have more than one project from which to choose, which one we should take. If this is the case, then why do so many financial managers in the “real world” make extensive use of the payback approach and, typically, do not take a discounted approach to payback? If you were to counsel a financial manager who is committed to using a payback criterion to evaluate prospective investments, would you take the opportunity to discuss other decision criteria that might be used? What advice would you provide as to whether he/she should continue using payback or if he/she should consider another approach and why?

Answer 1

For any Project / Major CAPEX evaluations, the three most common approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV).

The Payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

The Internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor

Net Present Value (NPV) is one of the preferred Captial budgeting tools used for assessing the feasibility of the Projects for capital investments. This is calculated by considering the total net cash inflows expected from a project and they are discounted to the present value using a discounting factor (generally the cost of capital or Weighted Average Cost of Capital WACC).

These cash flows are the free cash flows expected from the project - and covers in a more comprehensive way - Operational cash flows, Working capital changes, Asset sales, etc. The reason why discounting factor is used, is that the company has to fund this project either from its own sources or from external funding. In either of the case, there is a cost on the capital associated in either loss of interest income form or payment of interest cost form. Hence, it is considered to discount the future cash flows to the present value.

Payback period strictly looks at the time factor at which the investments are returned from the cashfows of the Project. From advantages perspective, this method is easy to apply, simple to understand, is useful incase of uncertainity and helps investors to this as a basic first step to analyse any project;

However , the disadvantages are that this method doesnt explain the profitabiliity of the project and Return of Investment is unknown;

Hence, this method need to be used along with the other capital budgeting tools, to make a proper decision.

Advantages and Disadvantages:

NPV: Key advantage is that cash flows from future periods is discounted back to the present to find their value as at present date. The NPV method gives the value indicates how much value the project will create for the company. Project Managers can understand how much a project will contribute to their value, in value terms.

Disadvantage is that NPV takes into consideration the only cash flows of a project. It fails to include other critical costs that can have an impact on the true value of the investment. These costs include opportunity costs and any other costs, etc. Also, dependency on the cost of capital for PV of future cash flows ignores the sensitivity of the discounting factor;

IRR: Advantage: This is very simple to use on various projects to assess based on the cost of capital / Hurdle rate / discounting factor; The IRR provides any small business owner with a quick glance of which projects would generate the greatest potential cash flows;

Main disadvantage of IRR is that it does not consider key factors like duration of the project duration, future costs or the size of a project. The IRR simply compares the project's cash flow to the project's current outflows, excluding all other factors;

Finally,

Payback Period: This is mainly useful for any business that is in to making relatively small investments, and so does not need to engage in more complex calculations that take other factors into account. It establishes a comfort to the project evaluators on when their initial outlay shall be covered.

Key disadvantages is that it ignores any cash flows post the Payback period; Incase of any negative cash flows post payback, this technique completely fails in assessing the same; Also, this technique is not helpful in assessing the profitability of a project.

Real use applications:

These techniques are used mainly in strategic investments which include major CAPEX investments including long term cash flows, Process changes, Business Valuations based on the expected net cashflows from the Business, Investments based on the expected return on the same (basic computations), etc; These help in assessing the profitability of the existing business by investing further in its operations, etc or rather by external business acquisitions.