Payback period

  • Disadvantages:
  • Considers cash flows within the payback period only: says nothing about project asa whole* or the profitability
  • Ignores size and timing of cash flows
  • Ignores time value of money (although discounted payback can be used)
  • It does not really take account of risk

Discounted Cash Flow Techniques

  • Net present value (NPV)
  • Internal rate of return (IRR)
  • Time value of money is taken into account
  • Applies a discount rate*
  • Example:
  • Project costing £1,000 is expected to yield £500 per year for 2 years. Cost of capital is 10%
  • What is the NPV?
  • Year Net cash flow (X) DF = PV
  • £ 10% £
  • 1 500 0.909 455
  • 2 645 0.826 532.77
  • 987.77
  • less initial cost 1,000
  • Net present value (12.23)
  • Would you accept the project?

2. Net present value (NPV)

Net present value

  • Difference between PV of future benefits and present value of capital invested, discounted at company’s cost of capital (hurdle rate)
  • NPV decision rule is to accept all projects with a positive NPV
  • With mutually exclusive projects, select project with highest NPV
  • Regarded as the best investment appraisal method by academics
  • Advantages:
  • Takes account of time value of money
  • Uses cash flow, not accounting profit
  • Takes account of all relevant cash flows over lifeof project
  • Can take account of conventional and non-conventional cash flows, as well as changes in discount rate during project
  • Gives absolute measure of project value

Net present value

Net present value

  • Disadvantages:
  • Project cash flows may be difficult to estimate (but applies to all methods).
  • Accepting all projects with positive NPV only possible in a perfect capital market.
  • Cost of capital may be difficult to find.
  • Cost of capital may change over project life, rather than being constant.

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