Capital Investment Appraisal

Payback Period

Measures the number of years taken to recover initial investment.

Payback Period Decision Rule

Accept project if the payback period is within the company's target payback period.

Net Present Value (NPV)

It involves discounting all relevant cash flows to their present value.

NPV Decision Rule

Accept if NPV>0, accept project with the highest NPV.

Internal Rate of Return (IRR)

the yield earned on an investment over the course of its economic life.

IRR Definition

It is equivalent to the discount rate that will cause the NPV of an investment to be zero.

IRR Decision Rule

Accept project if IRR > company's cost of capital, accept project with highest IRR.

NPV Reinvestment Assumption

assumes that any cash inflows generated during the life of the project will be reinvested at the cost of capital.

IRR Reinvestment Assumption

assumes that cash inflows can be reinvested elsewhere to earn a return equal to the IRR of the original project.

Sunk Costs

Already spent thus aren't relevant.

Apportioned Fixed Costs

Will be incurred whether or not project goes ahead, thus not relevant.

Opportunity Cost

Benefit foregone by using asset for this project.

Interest as Cash Flow

Interest is NOT a relevant cash flow, dealt with via cost of capital.

Payback Period Advantages

• simple to use

• easy to understand

• cash flow based

• focuses on imminent cash flows

Payback Period Disadvantages

• ignores time value of money

• ignores cashflow size/timing

• ignores cash flow outside payback period

NPV Advantages

• takes into account the time value of money

• takes into account the size of the investment

• takes into account the duration of the investment

NPV Disadvantages

• difficult to understand

• difficult to estimate cash flows

• difficult to determine discount rate

• by itself, insufficient in comparing NPVs across investments of different amounts

IRR Advantages

• takes into account the time value of money

• it takes all cash flows into consideration

• it uses cash flows instead of accounting profit

IRR Disadvantages

• relative measure and hence ignore the absolute values of payoff

• multiple and indeterminate IRRs are possible - and NPV has to come to the rescue

• inherent logic may be difficult to justify and explain to non-financial managers