Essentials of Financial Management

Jason Laws

Published by Liverpool University Press

Laws, Jason.
Essentials of Financial Management.
Liverpool University Press, 2018.
Project MUSE. muse.jhu.edu/book/72683.

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 5
Investment appraisal

5.1 Introduction to investment appraisal

In this chapter we will evaluate real investment decisions whereby entrepreneurs and
companies consider whether a certain level of investment will generate sufficient cash flows in
the future to make the investment worthwhile. In this section you will be introduced to three
main forms of investment appraisal: (i) payback, (ii) net present value (NPV) and (iii) internal
rate of return (IRR). We will also look at combinations of these.
Graham and Harvey 1 surveyed 392 chief financial officers (CFOs) and asked them a variety of
questions about capital budgeting decisions. They found that “Most respondents select net
present value and internal rate of return as their most frequently used capital budgeting
techniques; 74.9% of CFOs always or almost always ... use net present value … and 75.7%
always or almost always use internal rate of return …”
When asked to state, on a scale of 0 (never) to 4 (always), “how frequently does your firm use
the following techniques when deciding which projects or acquisitions to pursue?”, the mean
score was 3.09 for IRR, 3.08 for NPV and 2.53 for payback for the entire sample of firms.

1
John R. Graham and Campbell R. Harvey, ‘The theory and practice of corporate finance: evidence
from the field’, Journal of Financial Economics, 60.2–3 (2001), pp. 187–243,
https://doi.org/10.1016/S0304-405X(01)00044-7
ESSENTIALS OF FINANCIAL MANAGEMENT

However, for small firms the mean score was 2.87, 2.83 and 2.72 respectively, while for large
firms it was 3.41, 3.42 and 2.25 respectively. It is evident that payback is preferred by small firms
but NPV and IRR is more popular with large firms.

5.2 The net present value decision rule

We have previously seen that a dollar today is worth more than a dollar in the future. It is
therefore not appropriate to focus on the actual level of future cash flows, as in “present value”
terms they will decline over time. Therefore, if we wish to evaluate an investment project we
need to focus on discounted cash flows, not the actual level of cash flows.
Moreover, previously we have learned that equities and bonds carry with them different
degrees of risk and hence have different required rates of return. It follows that the interest rate
used to discount cash flows will vary from investment to investment.
The net present value of a project can be found by:

𝑇𝑇
𝐶𝐶𝐶𝐶𝑡𝑡
𝑁𝑁𝑁𝑁𝑁𝑁 = −𝐼𝐼0 + �
(1 + 𝑟𝑟)𝑡𝑡
𝑡𝑡=1

where I0 represents the initial investment in time period 0, CFt represents the cash flow in
period t, r is the required rate of return and T is the time of the final cash flow. Note that CFt can
be positive or negative. The nature of the cash flows that are considered in net present value
evaluation are referred to as incremental cash flows, i.e. cash flows that are added to a firm’s
existing cash flows as a result of accepting the project. In addition the project should consider
any external effects that the project would have. For example, cannibalisation is an externality
in which the investment reduces cash flows elsewhere in the company; for example, the launch
of a new product may take sales away from existing products.
Often when a project is being considered there would have been prior spending such as
marketing consultancy or a feasibility study. These costs are referred to as sunk costs and would
be incurred whether the project was accepted or not. As such, these costs would not affect the
future cash flows and should not be considered.

Example
Consider three investment projects, A, B and C, whose incremental cash flows are detailed
below. The sum of the three projects’ incremental cash flows are identical at $1.2m; however
the three projects differ in their timing, and as we have seen in section 5.1, the timing of the
cash flows influences the discount factor, which in turn influences the present values.

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 INVESTMENT APPRAISAL

Without doing any calculations, what would the ranking of the projects be?
Project/Year 0 1 2 3 4
A –$2m $1.6m $1.6m
B –$2m $1.6m $1.6m
C –$1m $1.6m $0.6m

As a dollar in the future is worth less than a dollar today, we will clearly prefer projects that
deliver cash in earlier periods. In this case we would favour projects A and C over project B. It
follows that we would also prefer projects that require less initial investment; hence we would
prefer project C over project A. The ranking is therefore: C then A then B.
The NPV decision rule is as follows:
accept any project if its NPV > 0 or if NPV = 0
reject a project if its NPV < 0
The notion that a project with a small, or even zero, NPV should be accepted often causes
bewilderment. The rationale is that as long as the project is evaluated at a discount rate
commensurate with its risk, then the providers of capital (bondholders and shareholders) are
receiving their expected return and hence the project should be accepted.
A very simple model of company valuation proposes a company’s value as:
value of net assets + present value of future opportunities
Hence if we accept a project, albeit with a very small NPV, then we are still increasing the value
of the company.

Example
Assume the cash flows from the construction and sale of student accommodation are as
follows:

Year 0 Year 1 Year 2

–$300,000 –$200,000 +$600,000

Assuming a 7% required rate of return, using the NPV decision rule would this project be
accepted?
If r = 7% = 0.07, then the three discount factors are:
Year 0: 1/1.07 = 1

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ESSENTIALS OF FINANCIAL MANAGEMENT

Year 1: 1/1.072 = 0.935

Year 2: 1/1.073 = 0.873
The NPV is then:
–$300,000 + 0.935 x –$200,000 + 0.873 x $600,000 = $36,800
On the basis of NPV we should therefore accept this project.
Note that the above answer assumes rounding to three decimal places. The actual answer, with
no rounding, is $37,147.35.
In section 4.1 you were introduced to the Excel function PV, which is able to find the present
value of a future stream of equal cash flows. It is not appropriate to use that function here and
instead we must use the NPV function. For example:
=npv(0.07,-200000,600000)
This returns the result $337,145.35, which represents the present value (at 7%) of cash flows of
–$200,000 and $600,000 in years 1 and 2 respectively. If we deduct from this the initial
investment of $300,000, we arrive at the previous answer of $37,145.35
Suppose you own a food van at a football stadium that sells pies, chips, burgers, soft drinks and
hot drinks. You have five years left on your contract and do not expect it to be renewed. Your
busiest period is the 15-minute half-time break, and long queues limit your sales. You have
developed three different proposals to reduce the queues and increase profits. The table below
shows the incremental cash flows.

Project/Year 0 1 2 3 4 5
Reconfigure van
to serve from –$75,000 $40,000 $40,000 $40,000 $40,000 $40,000
both sides
Install more
efficient –$25,000 $20,000 $20,000 $20,000 $20,000 $20,000
equipment
Buy a bigger van –$150,000 $60,000 $60,000 $60,000 $60,000 $60,000

You have decided that a 15% discount rate is appropriate, given the risk of the investment.
What is the NPV of each proposal?
Project/Year NPV
Reconfigure van to serve from both sides $59,086.20
Install more efficient equipment $42,043.10
Buy a bigger van $51,129.31

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 INVESTMENT APPRAISAL

Clearly the owner of the hot food van can only choose one of the outcomes. The projects are
therefore considered to be mutually exclusive. On the basis of the NPV calculations above, the
best decision is to reconfigure the van so that it can serve from both sides.
The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.2 tab at the bottom of the spreadsheet.

5.3 The relationship between NPV and discount rate

Consider once again the equation for the present value of a cash flow:
1
𝑃𝑃𝑃𝑃 = × 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
(1 + 𝑟𝑟)𝑡𝑡

The first term above is the discount factor. Hopefully it is evident that the larger is r, then the
larger the denominator and the smaller is the discount factor. Returning once again to the
example in section 5.2:

Year 0 Year 1 Year 2

–$300,000 –$200,000 +$600,000

As r increases, the present value of the positive cash flow will decrease. At the same time the
PV of the second construction payment in year 1 will also decrease, though that will be viewed
as an advantage from the investor’s point of view.
Using the NPV function in Excel it is trivial to plot NPV against the discount rate.

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ESSENTIALS OF FINANCIAL MANAGEMENT

From the chart above it is evident that there is a negative and non-linear relationship between
NPV and discount rates. It is also evident that eventually, as r increases, there is some discount
rate whereby the sum of the present values of future incremental cash flows exactly offsets the
cash flow in year 0 and the net present value is zero. In the chart above this appears to happen
at a discount rate of approximately 12%. Note that this diagram is near identical to the diagram
in Chapter 4 depicting the relationship between bond prices and yield to maturity, albeit here
we have a cash flow out in year 0 which causes the curve to shift downwards.
Revisiting a previous example:
Project/Year 0 1 2 3 4
A –$2m $1.6m $1.6m
B –$2m $1.6m $1.6m
C –$1m $1.6m $0.6m

At a discount rate of zero all three projects have an NPV of zero, but when depicted graphically
it is clear that, due to the latter’s cash flows, project B’s NPV becomes zero much sooner than
that of the other two projects.

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 INVESTMENT APPRAISAL

The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.3 tab at the bottom of the spreadsheet.

5.4 The internal rate of return

It is evident in the example above that there is some r for which the NPV of a project is zero.
This r is referred to as the internal rate of return (IRR). The formal definition of a project’s IRR is
the rate of discount which, when applied to the project’s cash flows, produces a zero NPV.
The IRR decision rule is then:
invest in any project that has an IRR greater than or equal to some predetermined
cost of capital
The comparison rate is usually the cost of capital, i.e. the discount rate we would have used in
an NPV analysis. This is often referred to as the hurdle rate, which makes logical sense, as r
reflects the riskiness of the project and, as the risk of the project increases, a higher IRR is
required to overcome the higher hurdle. The three projects, A, B and C, analysed earlier have
“standard” cash flows, i.e. up-front investment followed by cash inflows. For projects with
“standard” cash flows the relationship between NPV and r will be a negative one as depicted
in section 5.3 above.

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ESSENTIALS OF FINANCIAL MANAGEMENT

When the length of the project is two periods or less it is a trivial exercise to find the IRR. In
particular, returning to project C above, we are solving:
1.6 0.6
−1 + + =0
1 + 𝑟𝑟 (1 + 𝑟𝑟)2
Multiplying through by (1 + r)2:
−1(1 + 𝑟𝑟)2 + 1.6(1 + 𝑟𝑟) + 0.6 = 0

Setting (1 + r) = x:
−𝑥𝑥 2 + 1.6𝑥𝑥 + 0.6 = 0

which many students will recognise as a quadratic equation in the form:

𝑎𝑎𝑥𝑥 2 + 𝑏𝑏𝑏𝑏 + 𝑐𝑐 = 0

Hence, a = –1, b = 1.6 and c = 0.6.

The solution to a quadratic equation can be found as:
−𝑏𝑏 ± √𝑏𝑏 2 − 4𝑎𝑎𝑎𝑎
𝑥𝑥 =
2𝑎𝑎
−1.6 ± �1.6 − 4 × (−1) × 0.6
𝑥𝑥 =
2 × (−1)
x = –0.3136 or 1.9136
As x = 1 + r, then r = x – 1. We can therefore discard the solution –0.3136 and instead use the
other solution. Therefore the r that solves the above equation is 0.9136 or 91.36%. Note that
here the answer is independent of the amounts. For example, we would have found the answer
to be 91.36% regardless of whether the cash flows were –1m, 1.6m, 0.6m or –2m, 3.2m, 1.2m
or –1bn, 1.6bn, 0.6bn. Check this for yourself.
Excel has a built-in IRR function. For example, if you enter “=IRR({-1,1.6,0.6})” in Excel you will
obtain the answer of 91.36%.
Using the IRR function in Excel gives the internal rates of return to be 38% (project A), 14.4%
(project B) and 91.4% (project C), which corresponds with the order in the diagram in section
5.3.
The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.4a tab at the bottom of the spreadsheet.

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 INVESTMENT APPRAISAL

It is also possible to find the IRR of any project manually. Returning to the previous example of
the hot food van, buying a bigger van required a cash investment, in year 0, of $150,000. This
was followed by positive cash flows of $60,000 for the next five years.
If we have an initial estimate of the NPV at 20%, we find it to be $29,436.73. If we had returned
a negative value, we would then have tried a lower discount rate until we returned a positive
answer. Now we re-estimate the NPV at a higher discount rate, say 30%, and find the NPV to be
–$3,865.81.
We can then find the IRR via interpolation.
i0 = 0.2, i1= 0.3, NPV0 = 29,436.73, NPV1 = -3,865.81.
Inserting these values into the equation below:
𝑁𝑁𝑁𝑁𝑁𝑁0
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑖𝑖0 + (𝑖𝑖1 − 𝑖𝑖0 ) ×
𝑁𝑁𝑁𝑁𝑁𝑁0 + |𝑁𝑁𝑁𝑁𝑁𝑁1 |
29,436.73
𝐼𝐼𝐼𝐼𝐼𝐼 = 0.2 + (0.3 − 0.2) × = 28.84%
29,436.73 + |−3,865.81|
Note the pair of vertical lines indicates the absolute value.
The actual value for IRR, found using the IRR function, was 28.65%. The relationship between
NPV and r, for values of r from 20% to 30%, is depicted below. Essentially, the equation above
defines a chord between the coordinates (20%, $29,436.73) and (30%, –$3,865.81) and
determines where that chord intersects the horizontal axis.

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ESSENTIALS OF FINANCIAL MANAGEMENT

Example
A bespoke kitchen-maker can purchase a specialist machine for $40,000. The investment is
expected to generate $20,000 and $40,000 in cash flows for two years respectively. Using the
interpolation method outlined above, what is the IRR on this investment? If the kitchen-maker
views the risk of the project to be commensurate with a discount rate of 20%, would you accept
this project? Hint: use 25% as the initial guess and 35% as the higher guess.
i0 0.25
Year 0 1 2
CF –$40,000 $20,000 $40,000
PV –$40,000 $16,000 $25,600
NPV0 $1,600.00

i1 0.35
Year 0 1 2
CF –$40,000 $20,000 $40,000
PV –$40,000 $14,814.81 $21,947.87
NPV1 –$3,237.31

IRR 28.31%

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 INVESTMENT APPRAISAL

Note the “actual” IRR is 28.08%. If the hurdle rate is 20%, then on the basis of IRR this project
should be accepted.
The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.4b tab at the bottom of the spreadsheet.
You can change the initial guesses in the spreadsheet above and observe the impact on the
interpolated IRR. You should observe that the further apart the guesses are, the less accurate
is the IRR.

5.5 Pitfalls with using the internal rate of return

Certain cash flows can generate an NPV equal to zero at two different discount rates. Consider
a project with the following cash flows:

Year 0 1 2 3 4
Cash flow –$1,000,000 $800,000 $1,000,000 $1,300,000 –$2,200,000

The relationship between NPV and the discount rate is depicted below.

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ESSENTIALS OF FINANCIAL MANAGEMENT

For this project there exist two IRRs: one at approximately 6.6% and another at approximately
36.6%, making it impossible to apply the IRR decision rule.
Traditional projects that require an initial investment followed by several years of positive cash
flows generate a negative relationship between NPV and the discount rate. However, projects
where the cash flows switch from positive to negative (and perhaps back again) produce a
perverse relationship between NPV and the discount rate.
Consider a project with the following cash flows:

Year 0 1 2 3
Cash flow $20,000 –$72,000 $86,400 –$34,560

The relationship between NPV and the discount rate is depicted below.

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 INVESTMENT APPRAISAL

The IRR of this project is 20%.

This relationship is contrary to what we would normally expect. We would think that, since this
project has an IRR of 20%, we should accept it. But if the opportunity cost of capital is 10%, less
than the IRR, the project has a very small negative NPV and we should reject it.
The greatest weakness of the internal rate of return rule is its inability to handle mutually
exclusive projects. When we have mutually exclusive projects, only one can be selected. This is
in contrast to non-mutually exclusive projects where all those with a positive NPV should be
accepted, since by doing so the value of the firm is increased. Examples of mutually exclusive
projects include sole use of a scarce resource such as retail space or requiring one production
technique to produce a product.

Example
Suppose that the Davenport Corporation has two alternative uses for a very large warehouse.
It can store classic cars (investment A) or touring caravans (investment B). The cash flows are as
follows:
Year 0 1 2 3
Cash flow (A) –$200,000 $200,000 $20,000 $20,000
Cash flow (B) –$200,000 $20,000 $20,000 $240,000

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ESSENTIALS OF FINANCIAL MANAGEMENT

The chart below illustrates the NPV of these two projects at various discount rates.

Both projects require the same up-front investment. However, project B’s large cash flow
occurs in period 3, whereas project A’s large cash flow occurs in period 1. Consequently, at
lower discount rates the benefit from the extra net cash flow of $40,000 from project B makes
it the preferred project. But as the discount rate rises, and the $240,000 period 3 cash flow is
discounted more heavily, project A becomes the preferred project. The investment decision, at
various discount rates, is detailed below:
Discount rate NPV(A) NPV(B) Decision
5% $25,893.53 $44,509.23 Accept Project B
10% $13,373.40 $15,026.30 Accept Project B
15% $2,186.24 –$9,681.93 Accept Project A
20% –$7,870.37 –$30,555.56 Accept neither

Using the NPV decision rule it is therefore clear that the decision depends on the adopted
discount rate. There is one discount rate, 10.55%, where investors are indifferent between the
two projects. This is referred to as the crossover rate and how to calculate it is detailed in
section 5.6.

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 INVESTMENT APPRAISAL

Due to the pattern of the cash flows, the NPV of project B tends towards zero faster than that
of project A, and the two IRRs are 16.04% and 12.94% for projects A and B respectively. If we
assume a hurdle rate of, for example, 10%, it is tempting when using the IRR rule to select
project A, as the margin that the IRR has over the hurdle rate is larger. However, at a discount
rate of 10%, the NPV rule would select project B. Therefore, in the face of mutually exclusive
projects, the IRR rule is unable to distinguish between them.
The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.5a, 5.5b and 5.5c tabs at the bottom of the spreadsheet.

5.6 The crossover rate

The crossover rate is the discount rate at which the NPVs of two projects are equal.
Assume that the first project requires an investment of A and its cash flows at the end of years
1, 2 and 3 are CFA,1, CFA,2 and CFA,3; then the NPV is:
𝐶𝐶𝐶𝐶𝐴𝐴,1 𝐶𝐶𝐶𝐶𝐴𝐴,2 𝐶𝐶𝐶𝐶𝐴𝐴,3
𝑁𝑁𝑁𝑁𝑁𝑁𝐴𝐴 = 𝐼𝐼𝐴𝐴 + + +
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)3

If a second project requires an investment of B and generates cash flows of CFB,1, CFB,2 and CFB,3,
then the NPV is:
𝐶𝐶𝐶𝐶𝐵𝐵,1 𝐶𝐶𝐶𝐶𝐵𝐵,2 𝐶𝐶𝐶𝐶𝐵𝐵,3
𝑁𝑁𝑁𝑁𝑁𝑁𝐵𝐵 = 𝐼𝐼𝐵𝐵 + 1
+ 2
+
(1 + 𝑟𝑟) (1 + 𝑟𝑟) (1 + 𝑟𝑟)3
At the crossover rate the NPVs of the two projects are equal; hence we can find it by equating
the NPV for the first project with the NPV for the second project and solving for r:
𝐶𝐶𝐶𝐶𝐴𝐴,1
𝐼𝐼𝐴𝐴 + (1+𝑟𝑟)
𝐶𝐶𝐶𝐶𝐴𝐴,2 𝐶𝐶𝐶𝐶
𝐴𝐴,3
= 𝐶𝐶𝐶𝐶
𝐵𝐵,1 𝐶𝐶𝐶𝐶
𝐵𝐵,2 𝐶𝐶𝐶𝐶
𝐵𝐵,3
1 + (1+𝑟𝑟)2 + (1+𝑟𝑟)3 𝐼𝐼𝐵𝐵 + (1+𝑟𝑟)1 + (1+𝑟𝑟)2 + (1+𝑟𝑟)3

Example
Returning to the cash flows in the Davenport Corporation example:
Year 0 1 2 3
Cash flow (A) –$200,000 $200,000 $20,000 $20,000
Cash flow (B) –$200,000 $20,000 $20,000 $240,000

If we want to solve this manually, we must combine both sets of cash flows into one problem,
set the answer to zero and solve as in an IRR exercise:

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ESSENTIALS OF FINANCIAL MANAGEMENT

𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶

𝐴𝐴,1
𝐼𝐼𝐴𝐴 + (1+𝑟𝑟) 1
𝐴𝐴,2
+ (1+𝑟𝑟) 2
𝐴𝐴,3
+ (1+𝑟𝑟) =𝐼𝐼 + (1+𝑟𝑟)
3 𝐵𝐵
𝐵𝐵,1
1
𝐵𝐵,2
+ (1+𝑟𝑟) 2
𝐵𝐵,3
+ (1+𝑟𝑟) 3

Set this to zero by subtracting the NPV of project B from the NPV of project A:
𝐶𝐶𝐶𝐶𝐴𝐴,1 𝐶𝐶𝐶𝐶𝐴𝐴,2 𝐶𝐶𝐶𝐶𝐴𝐴,3 𝐶𝐶𝐶𝐶𝐵𝐵,1 𝐶𝐶𝐶𝐶𝐵𝐵,2
𝐼𝐼𝐴𝐴 − 𝐼𝐼𝐵𝐵 + + + − −
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)3 (1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2
𝐶𝐶𝐶𝐶𝐵𝐵,3
− =0
(1 + 𝑟𝑟)3
�𝐶𝐶𝐶𝐶𝐴𝐴,1 − 𝐶𝐶𝐶𝐶𝐵𝐵,1 � �𝐶𝐶𝐶𝐶𝐴𝐴,2 − 𝐶𝐶𝐶𝐶𝐵𝐵,2 � �𝐶𝐶𝐶𝐶𝐴𝐴,3 − 𝐶𝐶𝐶𝐶𝐵𝐵,3 �
𝐼𝐼𝐴𝐴 − 𝐼𝐼𝐵𝐵 + + + =0
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)3
(200,000 − 20,000) (20,000 − 20,000)
200,000 − 200,0000 + +
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2
(20,000 − 240,000)
+ =0
(1 + 𝑟𝑟)3
180,000 0 −220,000
+ + =0
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)3
180,000 220,000
− =0
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)3
180,000 220,000
=
(1 + 𝑟𝑟)1 (1 + 𝑟𝑟)3
180,000 220,000
=
1 (1 + 𝑟𝑟)2
220,000
(1 + 𝑟𝑟)2 =
180,000
220,000
𝑟𝑟 = � − 1 = 10.55%
180,000

The chart below confirms this result. It is clear that when the line representing the NPV of
project A intersects with the line representing the NPV of project B, then the “NPVA-NPVB” line
is zero.

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As both projects require the same investment, the project (A-B) can be considered as having
non-standard cash flows of +$180,000 in year 1 and –$220,000 in year 3. If we switch the
problem around and look at NPV of A – NPV of B, then the problem looks more familiar:

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As a rule it is easier to evaluate the projects at a discount rate of zero and subtract the smaller
NPV from the larger. At a discount rate of 0% the NPV of project B is $80,000, while the NPV of
project A is $40,000. It is then a trivial exercise to find the IRR via interpolation:
𝑁𝑁𝑁𝑁𝑁𝑁0
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑖𝑖0 + (𝑖𝑖1 − 𝑖𝑖0 ) ×
𝑁𝑁𝑁𝑁𝑉𝑉0 + |𝑁𝑁𝑁𝑁𝑁𝑁1 |
NPV of B-A at 5% = $18,615.70, NPV of B-A at 15% = –$11,868.17
IRR = 0.05 + (0.15 – 0.05) x [[18,615.70]/[18,615.79 + |–11.868.17|]] = 11.1%
The actual answer is 10.55%, and we would get closer to that if we chose guesses closer
together. Project B is preferred when the discount rate is less than 10.55%, but when the
discount rate rises to over 10.55% project A is preferred.
The spreadsheet for this exercise can be found here. Please ensure you click on Section 5 and
the 5.6 tab at the bottom of the spreadsheet.

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5.7 Payback
After net present value (NPV) and internal rate of return (IRR), the next most popular form of
investment appraisal is payback. According to Graham and Harvey, 56.74% of respondents
always or almost always stated that they used the payback approach. 2
Payback is extremely simple, as it merely calculates the time period taken to return the initial
investment. It is often quoted in years and months or years and fractions of a year. For example,
if a project requires an initial investment of $45,000 and returns cash flows of $15,000 per
annum for five years, it is evident that this project returns the investment in three years. The
payback period of three years would then be compared to the company’s internally
determined payback period, and if the project returns the investment within this payback
period it will be accepted; if it doesn’t, it will be rejected.
It is convention to assume that cash flows are evenly distributed throughout the time period.
For example, revisiting the previous project, if the cash flows were $20,000 per annum then the
payback period would be 2.25 years, as after year 2 $5,000 is outstanding and with a cash flow
of $20,000 in year 3 this would arrive 0.25 of the way through the year.
A clear advantage of payback is that it is easy to understand and calculate. It is often used as a
supplementary screening technique, especially in the case of mutually exclusive projects
where IRR is unable to select the most appropriate. An obvious disadvantage of the payback
approach is that it ignores the time value of money and ignores cash flows beyond the
company’s payback period. To overcome the issue of ignoring the time value of money it is
possible to use modified payback, whereby we determine the number of periods required not
to recover the actual level of cash flows, but the present value of cash flows.

Activity 5.1
Calculate the simple payback of a project that requires investment of $60,000
followed by annual cash flows of $25,000 for three years. Assuming a discount
rate of 5% per annum, then calculate the modified payback.

2
Graham and Harvey, ‘The theory and practice of corporate finance’, pp. 187–243.

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