Beyond NPV and IRR

It is most common to use NPV and/or IRR to make investment decisions. Because of their wide use, they will be easily understood by any manager.

However, there are other decision rules you may be asked to use in particular situations or given certain managers. This presentation will cover these rules, which are:

• Payback
• Discounted Payback
• Profitability Index

Note that we consider Modified IRR as a type of IRR, and cover it in its own presentation.

Payback

We choose some threshold value, which represents the maximum time we will allow for the project to 'pay us back'. We then calculate the point in time in which we expect to be paid back.

Decision Rule

If expected payback time < threshold, then "accept", else "reject".

Benefits of Payback

• Simple to implement.
• Doesn't require a discount rate.

Problems with Payback

• Threshold value is arbitrary.
• Doesn't consider how much is paid after the payback point.
• Ignores the time-value of money.
• Does not attempt to maximize shareholder wealth!

Should you ever use payback?

It makes sense to use payback for very small decisions, which are often made by departments with little financial training.

Discounted Payback

This decision rule calculates the time to payback using discounted cash flows. It again compares the calculated payback to a threshold value.

To calculate discounted payback, we'll need the project's discount rate.

If expected discounted payback time < threshold, then "accept", else "reject".

Benefits of Discounted Payback

Includes a discount rate which incorporates both:

• The time-value of money.
• The risk inherent in the project's cash flows.

Problems with Discounted Payback

• Arbitrary threshold.
• Cash flows after the payback point are not considered.
• Does not attempt to maximize shareholder wealth!

Should you ever use payback?

This method requires the calculation of the discount rate, at which point you would be better off just calculating NPV.

Profitability Index

This is defined as the ratio of the sum of the discounted cash flows, to the absolute value of the cost of the project.

If the Profitability Index > 1 then "accept", else "reject".

Benefits of The Profitability Index

• Includes a risk-appropriate discount rate.
• Includes all cash flows.
• Will give the same accept/reject decision as NPV.

Problems with The Profitability Index

• Same level of difficulty to calculate as NPV.
• Loses the scale of the project, so can't be used to rank mutually exclusive projects.

Interactive App

Credits and Collaboration

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