Net Present Value, payback period and IRR
- You will learn if an insurance plan is scamming you or do you actually
stand to earn from it
- Learn if you should actually invest in a company/investment
Net Present Value (NPV)
NPV is the difference between the market value of a project and its cost.
This is different from present value! NPV represents the value created, present value can be high but indicate a loss.
Investment Procedure:
Estimate the required return of projects at your risk level/ interest/ discount rate
Find the present value of the cash flow and subtract the initial investment, which gives you NPV
If NPV is positive, take the investment!
It's your criteria for the investment. For example, if you would like to breakeven within 2 years, that is your decision rule.
You are reviewing a new project and have estimated the following cash flows:
- Year 0: Cash Flow(CF) = -$165,000
- Year 1: Cash Flow(CF) = -$63,120. Net Income (NI) = $13,620
- Year 2: Cash Flow(CF) = -$70,800. Net Income (NI) = $3,300
- Year 3: Cash Flow(CF) = -$91,080. Net Income (NI) = $29,100
- Average Book Value = $72,000
- Required return for assets of this risk level is 12%.
Go through the answer walkthrough, then do yourself. Use google sheets/ excel, if you have financial calculator try it.
Here are the links to some excel formulas for this lecture if you need it
- NPV - Value creation from a series of cash flows
- IRR - Calculates the return needed to break even from a bunch of cash flows
It is important to understand the purpose of the financial ratio. Please go through these accordions.
Payback period
This represents how long it takes for you to get back your initial investment. In this question, your investment was $165,000 at year 0 (remember negative sign = money leaves you). Now, lets try to find the payback period for this question.
Evaluation of payback period
| Advantages | Disadvantages |
|---|---|
| Easy to understand | Ignores the time value of money |
| Adjusts for uncertainty of later cash flows | Requires an arbitrary cutoff point |
| Biased toward liquidity | Ignores cash flows beyond the cutoff date |
| Biased against long-term projects, such as research and development, and new projects |
The most glaring problem with using payback period is that there is a time cost in waiting to get $70,800 at year 2 (discount value). You could have invested that $70,800 elsewhere at year 0 and end up with say $72,000!
Introducing - discounted payback period (DPP)!
- You may have noticed that DPP end value is same as NPV, just different
signs. They are the same, provided that you are taking into account all cash
flows and not limiting DPP to say year 2 due to your decision rule.
- Number of years needed to breakeven with DPP calculation will always be more than that of payback period. This is because you are accounting for the discount rate for the cash flows.
Evaluating DPP
| Advantages | Disadvantages |
|---|---|
| Includes time value of money | May reject positive NPV investments |
| Easy to understand | Requires an arbitrary cutoff point |
| Does not accept negative estimated NPV investments when all future cash flows are positive | Ignores cash flows beyond the cutoff point |
| Biased towards liquidity | Biased against long-term projects, such as R&D and new products |
It is important to understand the purpose of the financial ratio. Please go through these accordions.
Internal Rate Of Return (IRR)
IRR represents the required rate of return needed for you to break even, taking into account all the cash flows.
If IRR is lower than required rate of return, you reject the project.
Is there a formula to calculate the required rate of return, based on a specific year? I will leave that up to you / some finance expert reading this to figure it out!
Average Accounting Return
Honestly, this is a pretty useless ratio.If you are worried about the direction of the company without any cash flow data, then use this.
Download Excel File Walkthrough