Net Present Value (NPV):
Internal Rate of Return (IRR):
Payback Period:
he Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred. The calculation of the Payback Period is best illustrated with an example. Consider Capital Budgeting project A which yields the following cash flows over its five year life. Year 0 1 2 3 4 5 Cash Flow -1000 500 400 200 200 100
To begin the calculation of the Payback Period for project A let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year. Net Cash Flow -1000 -500 -100 100 300 400
Year 0 1 2 3 4 5
Cash Flow -1000 500 400 200 200 100
Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime during the third year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:
Thus, the Payback Period for project A can be computed as follows: Payback Period Payback Period = 2 + (100)/(200) = 2.5 years Thus, the project will recoup its initial investment in 2.5 years. As a decision rule, the Payback Period suffers from several flaws. For instance, it ignores the Time Value of Money, does not consider all of the project's cash flows, and the accept/reject criterion is arbitrary. he Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to increase the value of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected. The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula:
where CFt = the cash flow at time t and r = the cost of capital.
The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for the project is 10%. Project A Year 0 1 2 3 4 5 Cash Flow $-1000 500 400 200 200 100 Net Present Value Project B Cash Flow $-1000 100 200 200 400 700
Project A:
Project B:
Thus, if Projects A and B are independent projects then both projects should be accepted. On the other hand, if they are mutually exclusive projects then Project A should be chosen since it has the larger NPV. The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).
where CFt = the cash flow at time t and
The determination of the IRR for a project, generally, involves trial and error or a numerical technique. Fortunately, financial calculators greatly simplify this process. The example below illustrates the determination of IRR. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for both projects is 10%.
Project A Year 0 1 2 3 4 5 Cash Flow $-1000 500 400 200 200 100
Project B Cash Flow $-1000 100 200 200 400 700
Internal Rate of Return Project A:
Project B:
Thus, if Projects A snd B are independent projects then both projects should be accepted since their IRRs are greater than the cost of capital. On the other hand, if they are mutually exclusive projects then Project A should be chosen since it has the higher IRR.
