Using the Payback Method, IRR, and NPV

Using the Payback Method, IRR, and NPV

FIN/571

Introduction

The purpose of week four’s individual assignment is for the writer to write a memo to management describing the use of internal rate of return (IRR), net present value (NPV), and the payback method in evaluating project cash flows and describe the advantages and disadvantages of each. Writer will also calculate five (5), time value money problems. Then, using Microsoft Excel, calculate the project cash flow generated by the provided Projects, A and B, using the NPV method, explain which project writer would select and why, and which project writer would select under the payback method. It should be noted that the discount rate for both projects is 10 percent.

Memo to Management.

TO: MANAGEMENT

FROM: Jazmin Pierce

SUBJECT: USING THE PAYBACK METHOD, IRR, AND NPV

DATE: July 8, 2019

The purpose of this memo is to describe the use of the net present value (NPV), internal rate of return (IRR), and the payback method in relation to project cash flows, and to identify the advantages and disadvantages of each technique.

Net Present Value

The NPV method for analyzing a project’s cash flow involves subtracting the present value of the cost of investing from the present value of the future cash flows that will be seen from the investment (Ross, Westerfield, Jaffe & Jordan, 2016). This method for selecting projects is used to compare mutually exclusive projects, with the project having the higher NPV normally being pursued (Magni, 2009). It is important to note that project with a negative NPV should be rejected, and those with a higher value will have a greater financial benefit to the company (Gallo, 2014). One advantage of the NPV is that it considers the time value of money (Gallo, 2014). This method is very beneficial when analyzing large projects such as mergers or acquisitions (Gallo, 2014). One disadvantage of this method is it can be difficult to explain to others.

Internal Rate of Return

The IRR is the discount or interest rate that connects the sum of the present values of a cash flow to a NPV of zero (Patrick & French, 2016). Similar to the NPV, the higher the IRR the higher the priority the project will receive (Goedhart, Levy, & Morgan, 2015). The IRR is used in a reject or accept manor with a predetermined required rate of return. If the IRR is above the required rate then the project can be accepted, but if it is below the required rate then it should be rejected (The Association of Chartered Certified Accountants, 2016). This method is advantageous because it also considers the time value of money. One disadvantage of the IRR is that it does not consider the relative size of the project (The Association of Chartered Certified Accountants, 2016).

Payback Period Method

The last and most criticized method used for project selection is the payback period method. The payback period method is the calculation of the amount of time required to recuperate the initial investment for a project (Awomewe, & Ogundele, 2008). An acceptable payback period is determined by management which is the threshold for passing or failing a project. According to Awomewe & Ogundele (2008), managers use the payback period method for projects which average 2.91 years. The main advantage of the payback method is that it is simple, and much easier to compute and explain compared to other techniques (Pike, 1985). The obvious disadvantage of the payback period method is that it does not consider the time value of money.

Example Projects

Based on the explained methods for evaluating projects for their financial feasibility the projects in Table 1 can be analyzed. Table 2 shows the calculated NPV, IRR, and Payback period for bother projects. In regards to all three evaluation methods project A would be the project that I would select to pursue. This is because it has a positive NPV, as well as a lesser payback period which is preferable. The IRR exceeds the discount rate of 10 percent for the project which is also preferable.

Table 1. Description of Two Potential Capital Projects

Project Initial Investment Year 1 Cashflow Year 2 Cashflow Year 3 Cashflow
A $ (10,000.00) $ 5,000.00 $ 5,000.00 $ 5,000.00
B $ (55,000.00) $ 20,000.00 $ 20,000.00 $ 20,000.00

Table 2. Comparison of NPV, IRR, & Payback Period Method

Project NPV IRR Payback Period
A $2,434.26 23% 2 years
B $(5,262.96) 4% 3 years

The example questions below show the use and importance of the time value of money.

References

  1. If you want to accumulate $500,000 in 20 years, how much do you need to deposit today that pays an interest rate of 15%?
  2. PV=fv/(1+r)n
  3. Fv=500,000 r = 15% n = 20
  4. PV +500,000/1+.15)20
  5. 500,000/16.37=30543.68
  6. What is the future value if you plan to invest $200,000 for 5 years and the interest rate is 5%?
  7. $200,000 x [1(.05 x 5)] = $200,000 [1(.25)] = $200,000 (.25) = $250,000
  8. What is the interest rate for an initial investment of $100,000 to grow to $300,000 in 10 years?
  9. Rate 300,000 100,000 10
  10. r = (Future Value / Present Value) (1/t) -1
  11. r = ($300,000/$100,000) (1/10) -1 = 0.1161
  12. 11.61%
  13. If your company purchases an annuity that will pay $50,000/year for 10 years at a 11% discount rate, what is the value of the annuity on the purchase date if the first annuity payment is made on the date of purchase?
  14. Present Value of Annuity= $50,000 x [(1-1/(1.11) 10)/.11]
  15. Present Value of Annuity= $50,000 x [5.8892]
  16. Payment amount per period: $50,000
  17. Number of payments: 10
  18. Discount rate: 0.11
  19. Present value of annuity: $ 294,461.60
  20. What is the rate of return required to accumulate $400,000 if you invest $10,000 per year for 20 years. Assume all payments are made at the end of the period.
  21. Payment amount per period: $10,000
  22. Number of payments: 20
  23. Present value $ –
  24. Future value $ 400,000
  25. Required rate of return: 6.77

Awomewe, A.F., & Ogundele, O.O. (2008). The Importance of the Payback Method in Capital Budgeting Decision. (Master’s thesis). Retrieved from: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.619.726&rep=rep1&type=pdf 

Gallo, A. (2014). A Refresher on Net Present Value. Retrieved from https://hbr.org/2014/11/a-refresher-on-net-present-value

Goedhart, M., Levy,C., & Morgan,P. (2015). A better way to understand internal rate of return. Retrieved from http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-better-way-to-understand-internal-rate-of-return

Magni, C.A. (2009). Investment Decisions, Net Present Value and Bounded Rationality. Quantitative Finance, 9(8), 967-979.

Patrick, M., & French, N. (2016). The internal rate of return (IRR): Projections, benchmarks, and pitfalls, Journal of Property Investment & Finance, 34 (6), 664-669. Doi:10.1108/JPIF-07-2016-0059

Pike, R.H. (1985). Owner-Manager Conflict and the Role of the Payback Method. Accounting and Business Research, 16(61), 47-51. Doi 10.1080/00014788.1985.9729294

Ross, S.A., Westerfield, R.W., Jaffe, J., & Jordan, B.D. (2016). Corporate Finance (11th ed.). New York, NY: McGraw-Hill Education.

The Association of Chartered Certified Accountants. (2016). The internal rate of return. Retrieved from http://www.accaglobal.com/us/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-technical-articles/the-internal-rate-of-return.html