Investment Appraisal: Payback, NPV, and IRR Analysis

Payback Period Analysis

Disadvantages of Payback Period

• Cash flows may be difficult to estimate, particularly in years beyond the next.
• The total amount of investment is ignored.
• Thus, an investment with an early payback may be preferred to one which, although it takes longer to payback, might generate a greater return.
• The method is absolute; there is no indication of what is an acceptable payback period, except, intuitively, it should be short.
• Not only is the yardstick flawed, its length can vary according to economic circumstances and the trading position of the firm.
• Cash flows after the payback point are ignored.
• The time value of money is not considered.

Advantages of Payback Period

• Easy to calculate.
• Shows the extent of “exposure” involved in invested funds.
• Works on cash flow (correct), thus does not need to consider depreciation, profits, and/or losses on sales of fixed assets, etc.

SHORT

Net Present Value (NPV)

Advantages of Net Present Value

• Net cash flows emphasize liquidity.
• The firm’s accounting policies with regard to profit, asset valuation, depreciation, etc., are not relevant.
• The time value of money, and thus future cash flows, is taken into account.
• Comparison of projects through the respective sizes of their NPVs is easy.

Disadvantages of Net Present Value

• Difficulties in estimating the timing of cash flows, as well as their magnitude.
• This becomes especially difficult with time periods well into the future.
• The choice of discount rate is subject to debate. It must reflect a realistic assessment of what the cost of capital is likely to be over the whole life of the investment.
• In times of uncertainty (forevermore?), the temptation is to overstate the percentage rate used to “allow a bit of leeway for the uncertainty of the future.”

Internal Rate of Return (IRR)

Advantages of Internal Rate of Return

• Using net cash flows emphasizes liquidity.
• The firm’s accounting policies with regard to profit, asset valuation, depreciation, etc., are not relevant.
• The time value of money, and thus future cash flows, is taken into account.
• The answer, in terms of a percentage, appears more “understandable” to management.
• The IRR can be compared to a “hurdle” rate adopted by the firm; this sets a rate above which all acceptable investments must lie.

Disadvantages of Internal Rate of Return

• Difficult to choose an appropriate rate if simple interpolation is being used.
• The concept is difficult to understand.
• The assumption that all cash inflows are reinvested at the prevailing IRR rather than some market rate (as in NPV) is fundamentally flawed.
• In some cases, particularly those with complex cash flows (inflows and outflows occurring throughout the period rather than one single outflow followed by a series of inflows), the solution to the IRR expression will have several “answers.”