There are numerous techniques of evaluating an investment which might be typically used by managers in both personal corporations and public corporations. Every of these measures is meant to be a sign of profit for a project or investment. Some of these measures imply the scale of the profit at a particular point in time; others provide the rate of return in line with period while the capital is in use or when reinvestments are included. This section of the essay will discuss the internal rate of return (IRR), payback period (PBP) and the net present value (NPV) approaches for a project evaluation.
The internal rate of return (IRR)
“The internal rate of return is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equals zero” (investinganswers.com), meaning IRR is the rate of return that makes the sum present value of future cash flows and the final market value of a project (or investment) equals its current market value. The higher a project’s internal rate of return, the extra desirable it is to adopt the investment or project.
Ross (2013) calls IRR, the most important alternative to NPV and Graham (2001) said it’s the most used measure for evaluating projects. Graham (2001) claims that in 2001 75,6 percent of CFOs use the IRR method when comparing and deciding between capital projects. “The basic rationale behind the IRR method is that it provides a single number summarizing the merits of a project” (Ross 2013). It doesn’t depend on anything except the cash flows of the project, because the number is internal or intrinsic. It is pretty similar to the NPV formula:
IRR can be mathematically calculated using the formula:
C0 – the cash outflow generated in length No= zero
C – the cash flow generated in the particular duration (the last duration being ‘n’).
IRR, denoted via ‘r’ is to be calculated with the aid of employing trial and blunders method or use built-in functions from excel.
There are several advantages when it comes to the IRR. But the main aspect is that it provides a need that NPV doesn’t; a rule that summarizes the information of a project in a single rate of return. A big plus is that it takes the TVM into consideration unlike the payback period method. After calculated, it is very simple to interpret and therefor easy to visualize for managers.
The main disadvantage is that the economies of scale are ignored. A second disadvantage is one that arises when there are conventional cash flows. In those cases the NPV will equal zero more than one time, which will lead to multiple IRRs. In these cases the IRR method simply cannot be used here. Actually, To deal with this difficulty, a modified internal rate of return is regularly used.
A third disadvantage to the IRR method is that it has impractical implicit of the reinvestment rate. Even though it is rarely the case where a firm has the same reinvestment rate, the IRR method implies this. It continues to assume that the firm will make another investment at the same rate even though that is close to impossible.
The payback Period
The payback period is described as the time required to get back the initial funding in an investment or project. The payback period technique of financial appraisal is used to evaluate capital initiatives and to calculate the return per year from the start of the investment till the accrued returns are identical to the value of the funding at which point the funding is said to had been paid back and the time taken to attain this payback is called the payback period. Longer payback periods are typically not desirable as investment options for most firms.
The payback approach is computed as follows:
Payback Period= Initial InvestmentCash Inflow per Period
The payback decision rule states that proper invesatments need to have less than maximum payback period chosen by management (Berk and DeMarzo, 2017). Payback is said to emphasise the management’s challenge with liquidity and the want to reduce risk via a rapid recovery of the initial funding. It’s frequently used for small expenditures which have apparent benefits that the usage of extra sophisticated capital budgeting strategies isn’t required or justified.
Lets quickly look at an example to how the payback period method works. Say a firm is handed a project where the initial investment is £50,000, and the cash flows for the next 5 years are £10,000, £20,000, £12,500, £7,500 and £15,000 respectively. This can be shown in Table I:
Year 0 1 2 3 4 5
Cash Flow(£) -50,000 10,000 20,000 12,500 7,500 15,000
We can also write down investments like the preceding with the notation:
(-£50,000, £10,000, £20,000, £12,500, £7,500, £15,000)
From the table we can see that the investment period would be after 4 years as £10,000 + £20,000 + £12,500 + £7,500 = £50,000. By looking at the multiplication on the last sentence it shows how easy it actually is to calculate the payback period, which is one of its biggest advantages. It allows the managers evaluation process to be done within a relative short time. Companies with limited cash are usually looking for the fastest recovering projects, as it will enhance the reinvestment possibilities for such firms.
However since the payback period method is so simple it is no surprise that it comes with a lot of flaws and shortcomings. The two biggest disadvantages for the PBP method is that it doesn’t take the timing of cash flows into consideration and it ignores the cash flows after the payback period. Let’s start with the first disadvantage.
If we compare project I and project II, where both have a payback period of 2 years. But project I has a cash flow of £80,000 the first year and £160,000 the second, while the cash flows for project II are £160,000 for the first year and £80,000 for the second. Since the large cash flows come first for project II, the net present value of the project is considerably higher even though the payback period for the two projects are identical. Hence the problem will be that when comparing the two projects with each other using the payback period it will be impossible to tell which one is better, while the NPV approach will show differently.
The second disadvantage is, as said earlier, that it ignores cash flows after the cut-off date. Again, lets use the example from Table I earlier and call it project A, and we add another project called project B. The cash outflows and inflows will be as the following:
Year 0 1 2 3 4 5
Project A (£) -50,000 10,000 20,000 12,500 7,500 (Project A paid back) 30,000 (Not included in the payback method)
Project B (£) -50,000 17,250 15,000 17,250 (Project B paid back) – –
Here we can see that the payback for project B is after 3 years, while project A still has 4 years. Now if a company was to follow all their investment decisions only based on the payback period method, it would choose project B as it has the shortest payback period of 3 years. But if we add up all the cash inflows the company would get for the different projects, project Y would break even while project A will make a profit of £30,000. Therefor company has to use the payback period wisely, so it doesn’t miss profitable projects where the cash inflows continue long after the cut-off date.
A third disadvantage with the PBP method is that it doesn’t consider time value of money. There is no discount rate for the inflows that occur in the later stages.