Net Present Value (NPV)

Net Present Value of a project is the sum of the present values of all the cash flows – positive as
well as negative, that are expected to occur over the life of the project. In other words, NPV is
the difference between an investment’s market value and cost. It is a measure of how much
value is created or added today by undertaking an investment.

The formula of NPV is:

Where,

 Ct = cash flow at the end of year t

 n = Life of the project

 k = discount rate (given by the projects opportunity cost of capital which is equal to the
required rate of return expected by investors on investments of equivalent risk).

 C0 = Initial investment

 1 / (1 + k )t = known as discounting factor or PVIF i.e present value interest factor.

Decision Criteria

I. If the NPV is positive, it means the investment would add value to the firm, so accept the
project
II. If the NPV is negative, it means the investment would subtract the value from the firm, so
reject the project
III. If the NPV is zero, it means the investment would neither gain nor lose value for the firm,
in such case we should be indifferent whether to accept or reject the project. This project
adds no monetary value. Decision should be based on other criteria such as strategic
positioning or other factors not explicitly included in the calculation.
IV. Assign the higher rank to the project with higher NPV and lower rank to project with
lower NPV.

Advantages of NPV

 It considers time value of money.

 It is a true measure of profitability as it uses the present values of all cash flows (both
outflows & inflows) & opportunity cost as discount rate.
 The NPVs of individual projects can be simply added to calculate the value of the firm.
 It is consistent with the shareholders wealth maximization principle as whenever a project
with positive NPV is undertaken, it results in positive cash flows and hence the increase
in the value of the firm.

Disadvantages of NPV

 It is difficult to estimate the expected cash flows from a project.

 Discount rate to be used is very difficult to determine.
 Since this method does not consider the life of the projects, in case of mutually exclusive
projects with different life, the NPV rule, tends to be biased in favour of the longer term
project.
 Since NPV is expressed in absolute terms rather than relative terms it does not consider
the scale of investment.
Internal Rate of Return (IRR)

The discount rate often used in capital budgeting that makes the net present value of all cash
flows from a particular project equal to zero. Generally speaking, the higher a project's internal
rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank
several prospective projects a firm is considering. Assuming all other factors are equal among
the various projects, the project with the highest IRR would probably be considered the best and
undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)".

The formula for calculating IRR is:

Where,

 Ct = cash flow at the end of year t

 n = Life of the project

 r = discount rate

 C0 = Initial investment

 1 / (1 + r )t = known as discounting factor or PVIF i.e present value interest factor.

IRR Illustrated

Initial outlay = -$200

Year Cash flow

1 50

2 100

3 150

Find the IRR such that NPV = 0

Decision Criteria

I. Accept the project when r (IRR) > k (WACC).

II. Reject the project when r (IRR) < k (WACC).
III. May accept the project when r = k.
IV. In case of independent projects, IRR and NPV rules will give the same results if the firm
has no shortage of funds.
V. In case of projects with equal IRR & different NPV, select project with higher NPV as it
is consistent with firm’s wealth maximisation objective.

Advantages of IRR

 It considers time value of money.

 It is a true measure of profitability as it uses the present values of all cash flows (both
outflows & inflows) rather than any other arbitrary assumption or subjective
consideration.
 In case of conventional independent projects NPV & IRR methods gives the same
decision.
 Whenever a project with higher IRR than WACC is undertaken, it results in the increase
in the shareholder’s return. Hence, the value of the firm also increases.

Problems with IRR

 Lending & Borrowing projects: Project with initial outflow followed by inflows is a
lending type project whereas a project with initial inflow followed by outflows is a
borrowing project. Since IRR does not differentiate between lending and borrowing
projects, a higher IRR may not always be a desirable thing.
 Multiple IRR: In case of projects with non-normal or unconventional cash flows more
than one IRR are generated which are misleading.
 Mutually Exclusive projects: In case of mutually exclusive projects the results of NPV &
IRR methods may conflict each other. This is because the IRR method does consider the
scale of investment.

 Different short term & Long term interest rates: Since the cash flows are discounted at
the opportunity cost of capital, there arises a confusion regarding what rate is to be used
for discounting, if the short term and long term lending rates are different.
Payback Period (PBP)
The payback period is the length of time that it takes for a project to recoup its initial cost out of
the cash receipts that it generates. This period is sometimes referred to as" the time that it takes
for an investment to pay for itself." The basic premise of the payback method is that the more
quickly the cost of an investment can be recovered, the more desirable is the investment. The
payback period is expressed in years.

PBP is calculated as:

For even cashflow:

For uneven cashflow:

There are four important points to be understood about payback period calculations:

1. This is an approximate, rather than an exact, economic analysis calculation.

2. All costs and all profits, or savings of the investment, prior to payback are included
without considering differences in their timing.
3. All economic consequences beyond the payback period are completely ignored.
4. Being an approximate calculation, payback period may or may not select the correct
alternative. That is, the payback period calculations may select a different alternative
from that found by exact economic analysis techniques.

Example: A company wants to buy a production device for their new factory. They have two
alternatives, whose cash flows are given in the following table. According to these cash flows,
determine the no return payback period of these alternatives.
 Alternative A Alternative B
Cost 3 000 000 TL 3 500 000 TL
Annual income 1 200 000 TL first year, 100 000 TL for the first year,
decreasing by 300.000 TL increasing 300 000 TL per
per year thereafter year thereafter.
Useful life 4 years 8 years

Alternative A

Years 0 1 2 3 4
Cash Flow -3 000 000 1 200 000 900 000 600 000 300 000
Cumulative value -3 000 000 -1 800 000 -900 000 -300 000 0

PBA= 4 years

Alternative B

Years 0 1 2 3 4 5
Cash Flow -3 500 000 100 000 400 000 700 000 1 000 000 1 300 000
Cumulative value -3 500 000 -3 400 000 -3 000 000 -2 300 000 -1 300 000 0

PBB= 5 years

According to the payback periods, alternative A should be preferred

Decision Criteria of PBP

 For independent project, accept those whose PBP standard PBP set by the firm.
 For mutually exclusive project, accept those which meets above condition and which one
has shortest PBP.
 Project that has shortest PBP is ranked 1.
Advantages

 The calculations can be easily made by people unfamiliar with economic analysis,
especially in analysis of no-return payback period. One does not need to know how to use
gradient factors, or even to have a set of compound interest tables. Second, payback
period is a readily understood concept.

 Payback period does give us a useful measure, telling us how long it will take for the cost
of the investment to be recovered from the benefits of the investment. Businesses and
industrial firms are often very interested in this time period: a rapid return of invested
capital means that it can be re-used sooner for the other purposes by the firm.

 The payback period may not be used as a direct figure of merit, but it may be used as
constraint: no project may be accepted unless its payback is shorter than some specified
period of time.
Disadvantages
 Ignores the time value of money
 Ignores cash flow beyond the payback period
 Biased against long-term projects such as research and development, and new projects
 Requires an arbitrary cutoff point.

Discounted Payback Period

The length of time until the accumulated discounted cash flows from the investment equals or
exceeds the original cost. We will assume that cash flows are generated continuously during a
period.

Simple Payback Period method does not considers the time value of money but we must consider
the time value of money because of inflation, uncertainty, and opportunity cost. Therefore,
discounted cash flow method is used to calculate the payback period (discounted payback
period).

Discounted PBP is calculated as:

Advantages of Discounted PBP

 Includes time value of money.

 Easy to understand.
 Does not accept negative estimated NPV investments.
 Biased toward liquidity.

Disadvantages of Discounted PBP

 May reject positive NPV investments.

 Requires an arbitrary cutoff point.
 Ignores cash flows beyond the cutoff date.
 Biased against long-term projects, such as research and development and new projects.

Example:

The initial cost is $600 million. The appropriate discount rate for these cash flows is 20%. Using
the discounted payback rule, should the firm invest in the new product?

Discounted
Accumulated
Year Cash Flow Present Value
Cash Flow

1 $200.00 166.67 166.67

2 $220.00 152.78 319.45

3 $225.00 130.21 449.66

4 $210.00 101.27 550.93

Here the project never pays back, so the project should not be selected.
NPV Vs IRR

The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two
faces of the same coin as both reflect on the anticipated performance of a firm or business over a
particular period of time. The main difference however should be more evident in the method or
should I say the units used. While NPV is calculated in cash, the IRR is a percentage value
expected in return from a capital project.

Due to the fact that NPV is calculated in currency, it always seems to resonate more easily with
the general public as the general public comprehends monetary value better as compared to other
values. This does not necessarily mean that the NPV is automatically the best option when
evaluating a firm’s progress. The best option would depend on the perception of the individual
doing the calculation, as well as, his objective in the whole exercise. It is evident that managers
and administrators would prefer the IRR as a method, as percentages give a better outlook that
can be used to make strategic decisions over the firm.

Another major shortfall associated with the IRR method is the fact that it cannot be conclusively
used in circumstances where the cash flow is inconsistent. While working out figures in such
fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for
the NPV method since all that it would take is the collection of all the inflows-outflows and
finding an average over the entire period in focus.

Evaluating the viability of a project using the IRR method could cloud the true picture if the
figures on the inflow and outflow remain to fluctuate persistently. It may even give the false
impression that a short term venture with high return in a short time is more viable as compared
to a bigger long-term venture that would otherwise make more profits.

In case of independent project, IRR and NPV give the same decision. However, in case of
mutually exclusive projects, the decision is rather conflicting. It is simply because; sometimes
comparison must be made between projects with different lives. And in such situation, NPV
usually favors projects with longer life.

The NPV and IRR rules leads to identical decisions provided two conditions are satisfied. First,
the cashflow of the project must be conventional, implying that the initial cashflows are negative
and the subsequent cashflows are positive. Second, the project must be independent meaning that
the project can be accepted or rejected without reference to any other project.

In order to make a decision between any of the two methods, it is important to take note of the
following significant differences.

Summary:
1. While the NPV will work better in helping other people such as investors in understanding the
actual figures in so far as the evaluation of a project is concerned, the IRR will give percentages
which can be better understood by managers.

2. As much as discrepancies in discounts will most likely lead to similar recommendations from
both methods, it is important to note that the NPV method can evaluate big long-term projects
better as opposed to the IRR which gives better accuracy on short term projects with consistent
inflow or outflow figures.

NPV vs Payback
In every business, it is crucial to evaluate the value of a proposed project before actually
investing on it. There are a number of solutions to evaluate this on a financial perspective and
among them are Net Present Value (NPV) and Payback methods. These two can measure the
sustainability and value of long-term projects. However, they differ in their computation, factors,
and thus vary in terms of limitations and benefits.

NPV, also known as Net Present Worth (NPW), is a standard method for using the time value of
money to appraise long-term projects. It calculates a time series of cash flows, both incoming
and outgoing, in terms of currency. NPV equates to the sum of the present values of the
individual cash flows. The most important thing to remember about NPV is ‘present value’. Put
simply, NPV = PV (Present value) − I (Investment). For instance, given $ 1, 000 for I, $ 10, 000
for PV; $ 10,000- $ 1,000 = $ 9, 000 = NPV. When choosing between alternative investments,
NPV can help determine the one with highest present value, specifically with these conditions: if
NPV > 0 accept the investment, if NPV < 0, reject the investment, and if NPV= 0, the investment
is marginal.
Payback method, conversely, is used to evaluate a purchase or expansion project. It determines
the period, commonly in years, in which there’ll be a ‘payback’ on investments made. It is equal
to the initial investment divided by annual savings or revenue or in math terms, Payback period =
I/CF (Cash flow per year. For example, given $10, 000 for I and $ 1, 000 for CF, 10,000/ 1, 000
= 10 (years) = Payback period. The shorter the payback period, the better the investment is. A
long payback means that the investment will be locked up for a long time; hence the project is
relatively unsustainable.

Net present value analysis removes the time element in weighing alternative investments, while
Payback method is focused on the time required for the return on an investment to repay the total
initial investment. Given this, Payback method doesn’t properly assess the time value of money,
inflation, financial risks, etc. as opposed to NPV, which accurately measures an investment’s
profitability. In addition, although Payback method indicates the maximum acceptable period the
investment, it doesn’t take into consideration any probabilities that may occur after the payback
period nor measure total incomes. It doesn’t indicate whether purchases will yield positive
profits over time. Thus, NPV provides better decisions than Payback when making capital
investments. Relying solely on Payback method might result in poor financial decisions. Most
businesses usually pair it with NPV analysis. As far as advantages are concerned, Payback period
method is simpler and easier to calculate for small, repetitive investment and factors in tax and
depreciation rates. NPV, on the other hand, is more accurate and efficient as it uses cash flow,
not earnings and results in investment decisions that add value. On the downside, it assumes a
constant discount rate over life of investment and is limited in predicting cash flows. Moreover,
the cons of Payback include the fact that it doesn’t take into account cash flows and profits after
the payback period and money value along with financial risks prior or during investment.
Summary:
 NPV and Payback methods measure the profitability of long-term investments.
 NPV calculates an investment present value, but eliminates time element and assumes
constant discount rate overtime.
 Payback determines the period on which a ‘payback’ on a specific investment will be
made. However, it disregards time value of money and the project’s profitability after the
payback period.
 Most businesses use a combination of the two to come up with an optimal financial
decision.

Conclusion

The examination of the three different investment appraisals presented here has clearly shown
that the various methods entail the risk of misinterpretation. It is possible to get three different
choices using the three different methods. And this may not always match the company’s
strategy. Adopting the payback rule, for example, only the cash flows to the recovery period are
observed. All subsequently incurred cash flows are ignored. In addition, all predominant cash
flows are on equal weight, regardless of whether an investment has a faster return or not. Even
the method of internal rate of return viewed on its own provides no reliable results for an
investment decision. IRR itself has many flaws like multiple IRRs, misleading the decision in
case of different scale of investment. Net Present Value also has many pitfalls but in comparison
to the other two methods, the use of NPV is rather beneficial. This is because NPV is the only
method that concerns the actual objective of the organization i.e value maximization of the firm.