Pros and Cons of NPV, IRR and Payback calculations

Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period are some of the most common metrics used in the calculations of quantified benefits and costs when justifying projects via business cases. Here I take a quick look at each one and the pro's of con's of using these metrics.

Net Present Value (NPV)

Description - Perhaps the mostly widely used technique for analyzing a potential investment opportunity or project is the net present value of cash flow or NPV approach. Using the NPV of cash flow technique we would discount all cash flows in our business case at the opportunity cost of capital - in most cases the weighted average cost of capital for a company. The business rule that is applied with this analysis is to accept all projects or investments where the NPV of cash flows is greater than zero - so we're looking for positive NPVs.NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

Pros - Accounts for the fact that the value of a dollar today is more than the value of a dollar received a year from now - that's the time value of money concept. The other strength of this measure is that it recognizes the risk associated with future cash flow - it's less certain

Cons - Does not give visibility into how long a project will take to generate a positive NPV due to the calculations simplicity. Our NPV rule tells us to accept all investments where the NPV is greater than zero. However, the measure doesn't tell us when a positive NPV is achieved. Does it happen in five years or 15? If at all. Another limitation of the NPV approach is that the model assumes that capital is abundant - that is there is no capital rationing. If resources are scarce, then the analyst has to look carefully at not just the NPV for each project they are evaluating, but also the size of the investment itself. Fortunately, there is another measure that can help overcome this weakness - the calculation of internal rates of return.

Internal Rate of Return (IRR)

Description - The internal rate of return, or discounted cash flow rate of return, offers analysts a way to quantify the rate of return provided by the investment. The internal rate of return is defined as the discount rate where the NPV of cash flows are equal to zero. The IRR can be calculated using trial and error (changing the discount rate until the NPV = 0). Generally speaking, the higher a project's internal rate of return (assuming the NPV is greater than zero), the more desirable it is to undertake the project. The rule with respect to capital budgeting or when evaluating a project is to accept all investments where the IRR is greater than the opportunity cost of capital. Under most conditions, the opportunity cost of capital is equal to the company's weighed average cost of capital (WACC).

Pros - It is widely accepted in the financial community as a quantified measure of return and it's also based on discounted cash flows - so accounts for the time value of money. And when used properly, the measure provides excellent guidance on a project's value and associated risk,

Cons - There are three well known pitfalls of using IRR that are worth discussing:
1. Multiple or no Rates of Return - if you're evaluating a project that has more than one change in sign for the cash flow stream, then the project may have multiple IRRs or no IRR at all.
2. Changes in Discount Rates - the IRR rule tells us to accept projects where the IRR is greater than the opportunity cost of capital or WACC. But if this discount rate changes each year then it's impossible to make this comparison.
3. IRRs Do Not Add Up - one of the strengths of the NPV approach is that if you need to add one project to an existing project you can simply add the NPVs together to evaluate the entire project. IRRs on the other hand cannot be added together so projects must be combined or evaluated on an incremental basis.


Payback Period

Description Payback allows us to see how rapidly a project returns the initial investment back to the company. In practice, companies establish "rules" around payback when evaluating a project. For example, a company might decide that all projects need to have a payback of less than five years. This is also referred to as the cutoff period.

Pros - Allows for an easy understanding by management and stakeholders of when the initial investment will be recouped. This allows go, no-go, decisions to be made based on simple cutoff date rules.

Cons - Does not take into account the time value of money. Discounted cash flow should be the preferred way to evaluate payback since it does recognize the time value of money. That is cash in the future is not worth as much as much as cash today. Payback period also ignores all cash flows that occur after the payback period is reached.


Related Posts:
- Payback Period
- NPV Definition and Sample Spreadsheets
- Parts of this article were sourced from a detailed analysis of the above at Money - Zine. For a detailed template covering the above click here to visit the site.