Let me help you improve your understanding of Net Present Value, Internal Rate of Return,
and the payback method, by running various scenarios and analyzing the impact on NPV,
IRR and payback.
Meet our project manager, Jane.
She is working on an investment project for her site.
Besides working on the technical specifications, she needs to put the numbers together to get
approval to move ahead with the project.
After working with various suppliers and the Operations Manager, Jane has come up with
the following estimates for the “Base Case” of the project.
The expected upfront investment is $1000, which is cash out.
The expected benefits are $400 per year, for four years, which is cash in.
Jane has documented her assumptions, and feels that these estimates are reasonably accurate.
Jane inputs her numbers into a spreadsheet that she received from a finance colleague.
With a 20% discount rate (or WACC) that is used for investment projects in the company,
the project has a Net Present Value (NPV) of $35, an Internal Rate of Return (IRR) of
22% and a payback period of two and a half years.
What do these numbers mean?
NPV needs to be bigger than zero, which at $35 it is.
Internal Rate of Return needs to be higher than the discount rate: 22% for the project
is higher than the 20% discount rate.
Payback period is 2.5 years.
Jane wants to make sure the numbers are calculated correctly, so she checks the Excel formulas
for NPV, IRR and payback period, which seem to be working fine.
After these verifications, Jane submits her project for approval.
She doesn’t get an immediate “yes” or “no”, but hears the words that every project
manager dreads: “You can do better than that…”.
Jane is at a loss.
What does she do now?
There are several ways to improve the financial attractiveness of a project, based on more
optimistic assumptions.
To make it easy to compare these, each of the improvement ideas
is worth $100 on a nominal basis.
The first idea, let’s call it A1, is to reduce the spending on the initial investment.
Jane changes the scope of the investment without losing functionality and benefits,
saving $100.
The second idea, A2, is to find additional benefits of $25 per year in each of the four years.
Incremental savings that she may have overlooked in the first draft of the project.
The third idea, A3, is to extend the benefits: one quarter in year 5.
Which of these variations on the original project do you prefer, or are they all equal?
Think about it, and please vote!
The first step in comparing the alternatives, is to translate them to their financial profile.
Project A1 has an upfront investment of $900, and four years of benefits of $400 each.
Project A2 has $1000 of upfront investment, and four years of benefits of $425 each.
Project A3 has $1000 of upfront investment, four years of benefits of $400 each, and a
fifth year of benefits of $100.
Let’s look at how their Net Present Value, Internal Rate of Return and payback period
compare to the base case, one by one.
Project A1 lowers the upfront investment by $100, from $1000 in the base case to $900.
As the investment cash outflow is already in today’s money (no discounting to present
value required), the NPV goes up by the full $100, from $35 to $135.
IRR goes up by an impressive 6%-points, from 22% to 28%, on the lower investment base.
The payback period decreases slightly, from 2.5 to 2.3 years.
Project A2 has additional benefits in year 1 through year 4.
As the incremental $25 per year has to be translated to today’s equivalent, the NPV
goes up by only $65, as money in the future does not have the same value as money now.
IRR goes up 3%-points, and payback period decreases very slightly to 2.4.
Project A3 has additional benefits added to the end of the project: one more quarter of
benefits in year 5, worth $100 on a nominal basis.
$100 five years from now, at a discount rate of 20%,
is only worth $41 today in present value.
IRR goes up 2%-points.
Payback does not move at all! What’s wrong?
Project A3 is obviously better than the base case, right?
Well, the payback method is unable to detect it.
It asks the simple question “How many years does it take to recover the initial investment?”.
The answer in the base case is 2.5 years, and the answer in version A3 is 2.5 years.
That’s why it is important to look at all three metrics: NPV, IRR and payback.
Not just at one of them!
Jane the project manager puts the ideas next to each other, and decides to submit version
A1 for approval: cutting the upfront investment.
This is clearly the most attractive alternative from the perspective of financial justification.
But once again, she does not get an immediate “yes” or “no”, but another response
that every project manager dreads: “What if…”.
What if we take all three alternatives, and make a best case scenario where we combine
the improvement ideas: cut the initial investment by $100, find $25 of incremental benefit in
each of the first four years, and extend the benefits to year 5 thereby squeezing another
$100 of benefits out of it at the end.
This scenario would get you an NPV of $240, IRR of 33%, and a payback period of 2.1 years.
Remember, project investment and benefit calculations are built on credible assumptions, and this
version might be just too good to be true!
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