Project appraisal techniques

The Payback method.

The payback period tells us the number of years required to recover the initial cash outlay
from the project’s expected net cash flows. It is the ratio of the initial cash outlay to the
annual net cash flows. Let us look at the following example.

Example: payback period with equal annual cash flows. A firm is considering a project
whose expected net, after-tax cash flows are as follows:

Initial Investment = $ 18 000.00

Annual cash flows = $ 5 600.00 per year for the next 5 years.

The payback period = 18 000 / 5 600 = 3.2 years.

Example: payback period with unequal annual cash flows .A project has the following
expected annual net, after-tax cash flows:

Year Expected Net Cash flow Cumulative Cash Flow

0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4 $ 4 000 $ 2 000
5 $ 4 000 $ 6 00

In this example, you can see that the payback period falls between 3 years and 4 years. To
get the actual payback period, we use the following formula:

Payback = year before full recovery + [unrecovered cost at start of year / cash flow during
year]

Therefore the payback period = 3 + [ 2 000 / 4 000 ] = 3.5 years.

Decision criteria
A company might have a standing policy that all projects must recover their full cost within
a certain period of time. If the payback for a particular project falls within this stipulated
period, then the project is acceptable. If, for example, the company policy payback was 3
years, then the project would be accepted. In this sense therefore, the payback period may
be said to be a rough measure of the risk associated with the project. The longer the
payback, the greater the risk, therefore the less acceptable a project is.

In the case of mutually exclusive projects, those with longer paybacks are eliminated in
favour of those with shorter paybacks. As for independent projects, those with shorter
paybacks would be ranked higher than those with longer paybacks.

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Criticism of regular payback.
The regular payback does not take into account the time value of money, assuming that cash
flows received in the future are just as good as cash flows received today. In this sense it
does not take into account the cost of capital. A project may be financed by both debt and
equity and we need to factor in the cost of obtaining these funds, using an appropriate
discount rate.

The payback provides information on how long funds will be tied up in a project.
Therefore, the shorter the payback, the greater the project’s liquidity. Since cash flows
expected in the distant future are generally riskier than near-term cash flows, the payback
can be used as a crude measure of risk. The company that is cash poor may find the method
useful in gauging the early recovery of funds invested.

The payback discriminates against longer term projects, which may turn out to be more
profitable for the shareholders, by ignoring the cash flows after the payback period. This is
demonstrated for you in the following example.

Example: The cash flows for projects X and Y are as follows:

Project X Project Y
Year 0 (10 000) (10 000)
Year 1 1 000 5 000
Year 2 2 000 3 000
Year 3 3 000 2 000
Year 4 4 000 1 000
Year 5 8 000 500

The payback period for project X is 4 years whereas that for Y is 3 years. If these projects
were mutually exclusive, Y would be accepted and X rejected. Project Y is, however, a
shorter-term project than X in that the cash flows of X show a rising trend and those for Y
are decline drastically after the payback period.

The Net Present Value [NPV]

The net present value is the difference between the present value of the initial cash outlays
and the present value of the cash inflows of the project, discounted at the cost of capital for
the project.

The steps to be followed in evaluating a project using the NPV method are as follows :

 Find the present value [PV] of each period’s cash flow, including both inflows and
outflows, discounted at the project’s cost of capital,
 Sum the PVs to find the NPV.
 If the NPV is positive, accept the project and if the NPV is negative, reject the project.
 For two or more projects, accept the project with the highest NPV, if the projects are
mutually exclusive. If the projects are independent, accept the project with the highest
NPV first and rank them accordingly.

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The NPV is found by the following formula :

n
NPV =  CFt / ( 1 + k )t
t = 0

Where, CFt = the expected cash flow at time t, and t is starting from year 0 up to year n.
and k is the project’s cost of capital. Let us start by looking at the following example.

Example: Calculating a project’s NPV (uneven cash flows). A project with an initial
investment of $ 1000.00 has been found to have the following expected net cash flows for
the next four years :

Year 1 = $500, year 2 = 400, year 3 = 300, year 4 = $100.

If the cost of capital is 10% the NVP of the project will be found as follows :

Year Expected Cash flow x PVIF10% = Present Value.

0 - $ 1000 x 1.0000 = -$ 1000.00
1 500 x 0.9091 = 454.55
2 400 x 0.8264 = 330.56
3 300 x 0.7513 = 225.39
4 100 x 0.6830 = 68.30
NPV = $78.82

On this basis, the project should be accepted.

Rationale for the NPV.

An NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the
invested capital and to provide the required rate of return demanded by the providers of the
capital used on the project [ both equity and debt ].

If the NPV is positive, the project’s cash flows are generating more than the required rate
of return [RRR]. Since the return to bond holders [the providers of debt capital] is fixed
[ the interest on debt], the extra return accrues solely to the firm’s stock holders [the
providers of equity capital,] who receive their return [dividend] only after the bond holders
have been paid their fixed amount. It therefore follows that if a firm takes on a zero-NPV
project, the position of the shareholders remains unchanged. The firm only becomes larger
to the extent of the size of the project, but the wealth of the shareholders, that is the price of
the company’s shares, remains constant.

If the firm takes on a positive-NPV project, the position of the shareholders is improved by
the amount of the NPV. Thus, if the firm takes on the project, the wealth of the
shareholders is increased directly by $78.82, thus enhancing the share price of the firm

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The Internal Rate of Return [IRR].

The IRR is the yield or rate of return generated by the project’s cash flows. It is the
discount rate which equates the present value of the project’s expected cash inflows to the
present value of the outflows, thereby producing an NPV of zero.

As illustrated below, suppose we had a project with an initial cash outlay of $1 000 and
cash flows expected over a period of four years. If we bring back the cash flows back to the
present, that is year 0, by discounting them at the cost of capital, these would be equal to $1
000.

Year 0 1 2 3 4

( 1 000 ) 500 400 300 100

= 1 000 

Now, let us work through the following example.

A company is trying to decide whether to buy a machine for $ 80 000.00. The machine
will save the company costs of $ 20 000 per year for five years and have a resale value of $
10 000 at the end of that period. What is the IRR ? ( Ignoring tax effects ).

The IRR is found by trial and error [interpolation] if one is not using a financial calculator.
We apply different discount rates to the cash flows until we get one which produces an
NPV of zero.

Try 9% :
Year Cash flow x PVIF = present value
0 ( 80 000 ) x 1.000 = ( 80 000 )
1 –5 20 000 x 3.890 = 77 800
5 10 000 x 0.650 = 6 500
NPV = 4 300

Since this is a positive NPV, we try a higher discount rate, say 12% :

NPV = [ 20 000 ( 3 605 ) + 10 000 ( 0.567 ) ] - 80 000

= - 2 230.
Since the NPV is negative, the required discount rate lies somewhere between 12 % and 9
%, as shown in the following diagram, known as the NPV profile of the project :

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FIGURE 4.1. : THE INTERNAL RATE OF RETURN
NPV ($)

IRR = 10.98%

$ 4 300

$0.00
9% 12%
Discount Rate (%)
-$ 2 230

The IRR is the discount rate that will result in a zero NPV, therefore lies somewhere
between 9% and 12%. It is found by the following formula :

IRR = A + [ a / (a + b ) ] [ ( B – A ) ]

Where A = the lower discount rate which produces a positive NPV,

a = the NPV resulting from a discount rate of A%,
B = the higher discount rate which produces a negative NPV,
b = the NPV resulting from a discount rate of B%.

Thus, in this example, the IRR is equal to 10.98%, which is approximately 11%.

The decision rule for the IRR is that we should accept the project if the IRR is greater then
the RRR, that is the cost of capital. If the IRR is less than the RRR, then the project should
be rejected. If we are comparing two mutually exclusive projects, we would take the one
with the higher IRR.

Rationale for the IRR.

The IRR is the return that is expected to be generated by the project's net cash flows,
assuming that all the cash flows are reinvested into the project. If the IRR exceeds the cost
of the funds used to finance the project [the RRR], a surplus remains after paying for the
funds, and this surplus belongs to the firm’s shareholders. Therefore, taking on a project
whose IRR exceeds the cost of capital increases the shareholders’ wealth.

The decision criteria is therefore that if the project's internal rate of return exceeds the
required rate of return, the project should be accepted.

The decision criteria for independent projects is to take those projects with a higher IRR
first. If the projects are mutually exclusive, we take on those projects with a higher IRR and
reject those with a lower IRR.

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Problems with IRR.
The use of IRR in appraising projects is fraught with problems. Firstly, the IRR ignores the
relative size of the projects, as shown in the following example :

Project A Project B
Year 0 (350 000) (35 000)
Year 1 – 6 100 000 10 000

Project A is 10 times bigger than project B, therefore more profitable, but both have the
same IRR of 18%.
Secondly, the IRR is not effective when it comes to unconventional cash flows. Study the
following two projects.

PROJECT A PROJECT B
Cash flows ($) Cash flows ($)
YEAR
0 ( 100 000 ) ( 120 000 )
1 ( 50 000 ) 50 000
2 60 000 80 000
3 90 000 ( 50 000 )
4 80 000 20 000

Project B is not a conventional project. As you can see, we have an outflow in year 0 which
is followed by two inflows before we get another outflow in year 3, which is followed by
another outflow in year 4. If the cash flows from the project are not conventional [out flows
followed by inflows, as in project A], there may be more than one IRR.

The equation for the IRR is a polynomial of n degrees, therefore it has n different roots or
solutions. All except one of the roots are imaginary numbers when the cash flows are
normal, therefore in the normal case only one value of IRR appears. For non-conventional
cash flows, there are multiple real roots, hence multiple IRRs. In the case of project B,
there would be two internal rates of return.

Thus, the IRR is inferior to the NPV method.