Many Firms Today Continue to Use Payback Method but Also Employ the Npv or Irr Methods

You've got a great idea for a new product that will increase revenue or a new system that will cut the company's costs. But how can you be sure that it's a worthwhile investment? Any time you propose a capital expenditure, you can be sure senior leaders will want to know what the return on investment (ROI) is. There are a variety of methods you can use to calculate ROI — payback, net present value, breakeven — and internal rate of return, or IRR.

What is payback period?

Payback is by far the most common ROI method used to express the return you're getting on an investment. Chances are you've heard people ask, "How long until we make our money back?" And that's exactly what the method shows you, "The time it takes for the cash flow from the project to return the original investment."

The shorter the payback period, the better. And it "obviously has to be shorter than the life of the project — otherwise there's no reason to make the investment." If there's a long payback period, you're probably not looking at a worthwhile investment.

The appeal of this method is that it's easy to understand and relatively simple to calculate.

How do you calculate it?

Here's what you do: Take the initial investment and divide it by how much cash you expect the investment to bring in each year.

Imagine that your company wants to buy a $3,000 computer that will help one of your employees deliver a service to your customers in less time. The computer is expected to last three years. At the end of each of the three years, the cash flow from the equipment is estimated at $1,300 — that's the amount of extra money your company will make because it's now providing this service to more customers.

Since the machine will last three years, in this case the payback period is less than the life of the project. What you don't know is how much of a total return it will give you over those three years.

This is the major limitation of the payback method, "It doesn't tell you much. After all, you probably don't just want to break even on your investment. You want to make money." This can lead to some deceiving calculations. Say, for example, the cash flow for the project was actually $3,000/year in Year 1 and nothing thereafter. According to the payback calculation, you'd have a payback period of one year, which would seem great: You get all your money back in one year. But without returns in future years you're not actually making anything on your investment.

How do companies use the payback method?

It's most commonly used as a "reality check" before moving on to other ROI calculations. "The best use of payback, in my opinion is to quickly check on the numbers before deciding whether to investigate the investment further."

Payback is often used to talk about government projects or relatively risky projects that are capital intensive. "Industrial and manufacturing companies tend to like payback" Companies that are cash strapped and don't have a lot of capital to spend may also focus on payback period since they are going to need the money soon.

What mistakes do people make when using the payback method?

One of the fundamental flaws in the method is you're not taking into account the time value of money, translating future cash flows into today's dollars. It's like comparing "cantaloupes to cabbages, because dollars today have a different value than dollars down the road,". The longer the projects go, the less likely they are to be accurate.

"Payback tells you when you will get your initial investment back, but it doesn't take into account the fact that you don't have your money for all that time", For that reason, net present value is often the preferred method.

Another flaw is that payback tells you nothing about the rate of return, which is a problem if your company requires proposed investments to pass a certain hurdle rate. Some people will use "discounted payback," a modified method that takes into account the discount rate. This is a much less straightforward calculation but it is "far superior," especially if you're only going to use the payback method. However, payback is really a "rough rule of thumb, not strong financial analysis." After you've calculated it, and if your investment looks promising, it's time to do a more rigorous analysis with one of the other ROI methods — breakeven, internal rate of return, or net present value.

What is net present value?

"Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment". In practical terms, it's a method of calculating your return on investment, or ROI, for a project or expenditure. By looking at all of the money you expect to make from the investment and translating those returns into today's dollars, you can decide whether the project is worthwhile.

What do companies typically use it for?

When a manager needs to compare projects and decide which ones to pursue, there are generally three options available: internal rate of return, payback method, and net present value. the net present value, often referred to as NPV, is the tool of choice for most financial analysts. There are two reasons for that. One, NPV considers the time value of money, translating future cash flows into today's dollars. Two, it provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return.

"It's far superior to the payback method, which is the most commonly used". The attraction of payback is that it is simple to calculate and simple to understand: when will you make back the money you put in? But it doesn't take into account that the buying power of money today is greater than the buying power of the same amount of money in the future.

Managers also use NPV to decide whether to make large purchases, such as equipment or software. It's also used in mergers and acquisitions (though it's called thediscounted cash flow model in that scenario). In fact, it's the model that Warren Buffet uses to evaluate companies. Any time a company is using today's dollars for future returns, NPV is a solid choice.

How do you calculate it?

No one calculates NPV by hand. There is an NPV function in Excel that makes it easy once you've entered your stream of costs and benefits. (Plug "NPV" into the Help function and you'll get a quick tutorial.

The calculation looks like this:

This is the sum of the present value of cash flows (positive and negative) for each year associated with the investment, discounted so that it's expressed in today's dollars. To do it by hand, you first figure out the present value of each year's projected returns by taking the projected cash flow for each year and dividing it by (1 + discount rate). That looks like this:

So for a cash flow five years out the equation looks like this:

If the project has returns for five years, you calculate this figure for each of those five years. Then add them together. That will be the present value of all your projected returns. You then subtract your initial investment from that number to get the NPV.

If the NPV is negative, the project is not a good one. It will ultimately drain cash from the business. However, if it's positive, the project should be accepted. The larger the positive number, the greater the benefit to the company.

Now, you might be wondering about the discount rate. The discount rate will be company-specific as it's related to how the company gets its funds. It's the rate of return that the investors expect or the cost of borrowing money. If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV. If the firm pays 4% interest on its debt, then it may use that figure as the discount rate. Typically the CFO's office sets the rate.

What are some common mistakes that people make?

There are two things that managers need to be aware of when using NPV. The first is that it can be hard to explain to others. The discounted value of future cash flows — not a phrase that trips easily off the nonfinancial tongue but it's worth the extra effort to explain and present NPV because of its superiority as a method. Any investment that passes the net present value test will increase shareholder value, and any investment that fails would (if carried out anyway), actually hurt the company and its shareholders.

The second thing managers need to keep in mind is that the calculation is based on several assumptions and estimates, which means there's lots of room for error. You can mitigate the risks by double-checking your estimates and doing sensitivity analysis after you've done your initial calculation.

There are three places where you can make misestimates that will drastically affect the end results of your calculation. First, is the initial investment. Do you know what the project or expenditure is going to cost? If you're buying a piece of equipment that has a clear price tag, there's no risk. But if you're upgrading your IT system and are making estimates about employee time and resources, the timeline of the project, and how much you're going to pay outside vendors, the numbers can have great variance.

Second, there are risks related to the discount rate. You are using today's rate and applying it to future returns so there's a chance that say, in Year Three of the project, the interest rates will spike and the cost of your funds will go up. This would mean your returns for that year will be less valuable than you initially thought.

Third, this is where people often make mistakes in estimating, you need to be relatively certain about the projected returns of your project. "Those projections tend to be optimistic because people want to do the project or they want to buy the equipment".

What is internal rate of return?

The IRR is the rate at which the project breaks even and it's commonly used by financial analysts in conjunction with net present value, or NPV. That's because the two methods are similar but use different variables. With NPV you assume a particular discount rate for your company, then calculate the present value of the investmen. But with IRR you calculate the actual return provided by the project's cash flows, then compare that rate of return with your company's hurdle rate (how much it mandates that investments return). If the IRR is higher, it's a worthwhile investment.

How is it calculated?

It's not a straightforward calculation. For example, say you're proposing a $3,000 investment that will bring in $1,300 in cash for each of the following three years. You can't just use the $3,900 total cash flow to figure the rate of return because it's spread out over three years. Instead, you'll have to use an iterative process where you try different hurdle rates (or annual interest rates) until your NPV is equal to zero.

Luckily, you can easily calculate IRR in Excel or on a financial calculator. "There's no point in going through the math, because it's always done electronically".

How do companies use it?

Companies generally use both NPV and IRR to evaluate investments, and while NPV tells you more about the return you can expect, financial analysts "often rely on IRR in presentations to nonfinancial folks." That's because IRR is much more intuitive and easy to understand. "If I have a project where IRR is 14% and our corporate hurdle rate is 10%, your audience thinks, 'Oh, I get it. We get 4% more return on this project". Whereas if you said the NPV on this project is $2 million, your audience may ask for a reminder of what NPV is and nod out before you get even partway through your explanation that "it means the present value of the future cash flows of this investment using our 10% corporate hurdle rate exceeds our initial investment by $2 million."

The downside is that IRR is much more conceptual than NPV. With NPV you've quantified the contribution to the overall company: Assuming all of the assumptions are correct, this project will bring in $2 million. IRR doesn't give you real dollars. Similarly, it doesn't address the issues of scale. For example, an IRR of 20% doesn't tell you anything about the amount of money you'll get. Is it 20% of $1 million dollars? Or of $1? You don't have to be a math whiz to know there's a big difference between the two.

What mistakes do people make when using IRR?

The biggest mistake is to use IRR exclusively. It's much better to analyze a project using at least one of the other methods — NPV and/or payback. Using it alone could lead you to make a poor decision about where to invest your company's hard-earned dollars, especially when comparing projects that have different durations. Say you have a one-year project that has an IRR of 20% and a 10-year project with an IRR of 13%. If you were basing your decision on IRR, you might favor the 20% IRR project. But that would be a mistake. You're better off getting an IRR of 13% for 10 years than 20% for one year if your corporate hurdle rate is 10% during that period.

You also have to be careful about how IRR takes into account the time value of money. IRR assumes future cash flows from a project are reinvested at the IRR, not at the company's cost of capital, and therefore doesn't tie as accurately to cost of capital and time value of money as NPV does. A modified internal rate of return (MIRR), which assumes that positive cash flows are reinvested at the firm's cost of capital and the initial outlays are financed at the firm's financing cost, more accurately reflects the cost and profitability of a project.

Still, it's a good rule of thumb to always use IRR in conjunction with NPV so that you're getting a more complete picture of what your investment will give back.

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Source: https://www.chathams.co/1311-2/

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