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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