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The payback period is a simple calculation of the total time required by an investment to payback the initial outlay. The concept is simple, but it ignores several important factors, and any decision made on the basis of payback period can be harmful, if other factors are taken into account. One of the most important concepts in finance is the time value of money, which states that money loses its worth over time. Hundred dollars today are worth more than hundred dollars a year from now. Similarly, hundred dollars today are worth less than a hundred dollars a year ago. Furthermore, payback period calculations also ignore the size of the investment. The bottom line of the payback period is the time it takes to recover the money, but it does not take into account the amount of money that needs to be recovered. This can be very misleading at several times. For instance, if you have two investment alternatives, in the first option you need to invest $1,000, and in the second option you need to invest $10,000. They payback periods are 1 year and 2 years, respectively. A decision based purely on the payback period would favor the first investment option. However, it is obvious that the two alternatives are not comparable just on the bases of the payback period. For instance, the 2nd option is much more attractive from the point of view that it returns $5,000 per year, whereas, the first option only returns $500 a year. Another flaw of the payback period is that it ignores the future cash flows, the ones that are earned after the payback period. Two projects with the same payback period may have drastically different future cash flow patterns. Thus, it is not safe to make the decision purely on the basis of payback period calculations. The payback periods of the present alternatives are as under:
Discounted Payback period
The discounted payback period for both the projects is as under:
The discounted payback period provides more credible results than the simple payback period. However, I would still not recommend the use of this method. It is better than the simple payback period because it takes into account the concept if time value of money, which is certainly a very important concept. However, it still ignores the other factors, as mentioned above. The magnitude of the two projects is totally ignored, and the future cash flows are still not used in the calculations. A decision based on the basis of discounted payback period would be better than the one based on simple payback period, but it would still be flawed.
Accounting Rate of Return
The accounting rate of return for the two projects is as under:
If the management wants to earn an ARR of near 40% they should opt for the Epoxy raisin project. However, the synthetic raisin project is generating a higher, i.e. 52%, accounting rate of return. This decision is still not correct because the management is still ignoring several other factors. First of all, the ARR method also ignores the concept of time value of money, as the cash flows are taken in absolute terms, and are not discounted at all. Secondly, ARR is a percentage; it is misleading because it ignores the magnitude of the project. For instance, if two projects have equal ARR, then the management would be indifferent between the two projects. However, if one project requires an initial investment of %100,000 and the other project requires and initial investment of $1,000,000. Then if the ARR is 10%, it means that the first project would return $10,000, whereas, the second project would return $100,000. This fact is ignored in the accounting rate of return calculations. Therefore, I would not recommend the use of this method either.
Internal Rate of Return
The IRR of the two projects is as under:
Using IRR as the deciding factor, Epoxy raisin project generates better returns. However, this is still not a very refined method for decision making purposes. It has almost the similar problems as the ARR method. First of all, it is a percentage and ignores the magnitude of the project. In some cases a project with a lower IRR but larger magnitude can add more value to the company than a project with higher IRR and smaller magnitude. Furthermore, IRR method is useful when judging a single project instead of two mutually exclusive ones. In that case the decision to invest or not can be made on the basis of the return requirements of the company. However, if the decision is to be made between two projects, then the IRR method does not deliver the best results.
Net Present Value
The NPV of the two projects is as under:
NPV is the best method to decide between the alternate investment opportunities available, for the reason that it takes into consideration almost all the important factors. First of the all, the time value of money is not ignores, instead it is one of the basic assumptions of NPV. Secondly, the magnitude of the projects is taken into account, as well. The calculation of NPV involves actual figures and not percentages, which can sometimes be misleading. Also, it does not base the decision on the basis of recovering the initial investment only. It takes into account all the cash flows, the ones in the payback period and the ones after the payback period, as well. Lastly, it provides a very clear decision making process. If the NPV is greater than “0” it means that the project will add value to the company, and if it is less than “0” then it is not worth investing. This is known as the crossover point.
Modified Internal Rate of Return
Modified internal rate of return is an advanced or modified form of the IRR. As already mentioned, IRR is useful in case of a single project evaluation, but since it ignores the effect of project magnitude it cannot be used for mutually exclusive projects. However, MIRR takes into account this factor and thus it is a more realistic measure to be used in case of mutually exclusive projects.