1 Introduction2 Summary of Ranking Methods 2.1 The Undiscounted Payback Method .2.2 The Discounted Payback Period 2.3 Net Present Value (NPV) Technique 2.4 The Internal Rate of Return (IRR) Method .2.5 Net Future Value (NFV) Technique3 Example of the Determination of the DiscountedCashFlow Selection Criteria for a Project4 Concluding Remarks
Comparison of mutually exclusive alternatives, which means analysis of several alternatives from which only one can be selected (such as selecting the best way to improve an existing operation or choosing the best of several to develop)
Ranking non-mutually exclusive alternatives which means analysis of several alternatives from which more than one can be selected depending on capital or budget restrictions (such as ranking research or development projects to determine the best ones to fund with).
The payback period methods, being the number of years (or time periods) required to return the original investment. The payback period is usually determined on an undiscounted basis, but discounted payback periods must also be established for a project. (See sections 1.2.1 and 1.2.2)(2)
The net present value (NPV) method: being the present value of future benefits discounted at the appropriate cost of capital, minus the present value of the capital cost of the investment. (See section 1.2.3)
The internal rate of return (IRR) method: being the discount rate which equates the present value of benefits to the present value of the capital expenditure. (Section 1.2.4)
The net future value (NFV) method: being the future values of benefits compounded at the appropriate cost of capital, minus the future value of the investment cost compounded at the same cost of capital. (See section 1.2.5)
Assume that two projects are being considered by a company. Each requires a capital investment of $10,000. The marginal cost of capital is 10%. The net cash flows (i.e. net operating incomes after taxes plus the depreciation allowance) from the investments A and B are shown in the following table.
Year A B1 5,500 1,0002 4,500 2,0003 2,000 3,0004 10 4,0005 10 5,000
The payback period is the number of years it takes to recover the initial investment from after tax cash flow profits. It is observed that project A has a 2 year payback period, whilst project B has a 4 year payback period. If the firm employed, say, a two or three payback period selection criterion, project A would be accepted, and project B would be rejected.
As flaws in the simple undiscounted payback method were recognized, people began to search for methods of evaluating projects that would recognize the time value of money, and that would not automatically discriminate against projects which show their greatest profitability later on in the future. This recognition led to the development of discounted cash flow (i.e. DCF) techniques to take account of the time value of money.
It is important to emphasize that if the investment capital is expended over a period of several time periods, rather than as a lump sum at the beginning of the project, then the investment amounts for each time period should also be discounted and summed before being subtracted from the sum of the discounted income cash inflows.
The internal rate of return (IRR), sometimes called the discount cash flow rate of return (DCFROR) or simply the rate of return (ROR) is defined as that discount rate found by trial and error which equates the total present value of the expected after tax income cash flows (or benefits), to the total present value of the capital cost outlays (i.e. both working capital and fixed capital).
The significance of the internal rate of return is that if it has a value which is greater than the marginal cost of capital for the firm, then the value of the firm will increase. Naturally then, the project with the highest IRR would be expected to increase the value of the firm the most. However, project risk must also be taken into account when making a final decision.
A real understanding of the use of the ranking techniques comes only with the actual practical use of the techniques. The selection of project time period and discounting rate, and the estimation of initial capital expenditure, as well as incomes and costs to determine cash flow figures is most important when undertaking economic evaluations. "Garbage in = garbage out"!
It is good practice for technical personnel to liaise closely with the financial project evaluation personnel. Better still, technical personnel should first attempt to undertake their own preliminary economic evaluations. Then, in the event of the economic project selection criteria not being satisfied, the technical personnel can communicate meaningfully with the financial personnel to find out the major reasons why the project has not been acceptable. They can then go back to the process to try and establish whether opportunities exist to overcome the economic deficiencies. For example, leasing of equipment can substantially reduce the upfront capital requirements.
Although the techniques described in this section have been applied to the ranking of multiple mutually exclusive and non-mutually exclusive projects, many of the techniques can be used to evaluate the profitability of an individual project on its own.
n Although not mentioned before, it is important to appreciate that "sunk costs", or costs incurred in the past, tend to be irrelevant when considering economic decisions for the future. One should not become emotionally attached to projects on which much time and/or money has already been spent. If at any time another project arises which can clearly be shown to be a better investment opportunity, then it should accordingly be ranked higher than the sentimental project. It is no good crying over spilled milk - the past is gone and it is the future that counts. Do not “throw good money after bad”.
One should always bear in mind the concept of “opportunity cost". Thus if an opportunity exists to undertake a more profitable project, and a less profitable one of equivalent risk in fact chosen - an opportunity cost has been incurred in the sense that the opportunity to earn more profit has been forfeited. However, sometimes non-quantitative aspects such as strategic, health, safety or environmental considerations could swing the decision in favor of the less profitable option because of the gains to be made in other respects.