Question

After the company has accessed the cost and benifits of it investment it must compare them. Can you breifly explain any two of the most common approaches and give example of each?

Answer 1

	The two most common approaches are the Payback period and the NPV [Net present value]:
	Consider the following example. The investment has an initial cost of $670000 followed by benefits
	in the form of cash inflows in years 1 to 6, during which the project will last.
	Year	Benefits [Cash flow]
	0	$            -6,70,000
	1	$             2,50,000
	2	$             2,00,000
	3	$             1,70,000
	4	$             1,50,000
	5	$             1,30,000
	6	$             1,30,000
	1] PAYBACK:
	The payback period is the number of years taken for the cash flows to repay the amount invested.
	It can be found out by constructing the cumulative cash flows as below:
	Year	Cumulative Benefits [Cash Flow]
	0	$            -6,70,000
	1	$            -4,20,000
	2	$            -2,20,000
	3	$               -50,000
	4	$             1,00,000
	5	$             2,30,000
	6	$             3,60,000
	It can be seen from the cumulative benefits column that, the project investment is fully repaid in
	the course of the 4th year. At the end of the 3rd year the investment remaining to be recouped is
	$50,000. So part of 4th year is needed, which is, 50000/150000 = 1/3rd of a year. So payback period
	is 3 and 1/3 years or 3 years and 4 months.
	The payback period tells us how many years one has to wait till the investment is taken back. One
	can decided on an upper limit say a number of years as the maximum payback acceptable. It the
	payback period of the investment is less than that maximum, the project can be accepted. If not
	it should be rejected.
	By emphasising the need to take back investment early, the payback reduced the risk. But, the
	payback has drawbacks like not considering time value of money, not considering benefits after
	the payback period.
	NPV:
	This is a technique under the discount cash flow technique [DCF].
	The cash inflows or benefits are discounted using the minimum required rate of return and the
	PV of the cash inflows at t0 is found out. From the sum of the PV of the cash inflows, the initial
	investment is subtracted to give the NPV. If the NPV is positive the investment is viable; other-
	wise not. NPV is the addition to shareholders' wealth in dollar terms and hence highlights
	whether the shareholders' wealth is maximized.
	Assuming a discount rate of 11% the NPV is calculated below:
	Year	Cash flow	PVIF at 11%	PV at 11%
	1	$             2,50,000	0.90090	$ 2,25,225
	2	$             2,00,000	0.81162	$ 1,62,324
	3	$             1,70,000	0.73119	$ 1,24,303
	4	$             1,50,000	0.65873	$        98,810
	5	$             1,30,000	0.59345	$        77,149
	6	$             1,30,000	0.53464	$        69,503
	Total PV of cash inflows or benefits	$ 7,57,314
	Less: Initial investments		$ 6,70,000
	NPV			$        87,314
	As the NPV is positive, it means that the shareholders' wealth is increased and hene the
	investment is viable.
	The NPV takes into account the time value of money and it considers the cash flows during the
	whole life of the investment.