Economic Evaluation Techniques

Techniques for judging investment worth vary from comparatively crude, simple tests to quite rigorous measures. Some of these techniques are:

• Payback Period
• Net Present Value
• Internal Rate of Return.

This document also compares these methods.

Payback Period

Payback has been widely used in the past because of its simplicity, and because of the commonly asked question: "how long will it take before funds committed to works of a capital nature (usually accompanied with high risk) would be recovered?"

Payback is the period it takes to recover your initial investment.

The payback method is calculated by adding each year's earnings/benefits and noting the time period until all cash inflows equal total cash outflows.

Advantages

• Easy to use and understand
• Effectively handles investment risk
• Does not have to know the opportunity cost of capital (OCC)
• Provides test of liquidity
• Can be used as a supplement to other more sophisticated techniques, since it does not include risk.

Disadvantages

• Ignores the time value of money
• Does not consider cash flows received after the payback period
• Does not measure profitability
• Does not indicate how long the maximum payback period should be
• May give rise to a wrong decision if there is a reversal of cash flows in the future.

Net Present Value

The present value method compares the present value of future cash flows expected from an investment project to the initial cash outlay for that investment.

Net cash flows are the difference between forecasted cash inflow received because of the investment and the expected cash outflow of the investment.

Advantages

• Considers the time value of money
• Measures actual worth using standard of profitability
• No ambiguities/anomalies in options comparison.

Disadvantages

• Tedious calculation (without the aid of computers)
• Need to know organization's opportunity cost of capital
• Need to have consistent time frame for analysis
• The subjectivity in determining expected annual cash inflows and expected period of benefit.

Internal Rate of Return

This is the discount rate at which the present value of the costs equals the present value of the benefits.

It represents the rate of return on the investment in the project.

The internal rate of return assumes cash inflows are reinvested at the internal rate.

It is a measure of the profitability (or earning power) as a return per unit of capital per unit time it is invested.

This method involves trial-and-error computation.

The IRR can be compared with the required rate of return (cut off or hurdle rate). If the IRR equals or exceeds the required rate, the project is accepted.

The required rate of return is typically a organization's cost of capital, adjusted for risk.

Advantages

• Considers the time value of money
• Measures the profitability
• Do not have to know OCC (although the hurdle rate is required)
• More realistic and accurate than the accounting rate of return method.

Disadvantages

• Difficult and time consuming to compute, particularly when there are uneven cash flows
• Does not consider the varying size of investment in competing projects and their respective dollar profitabilities
• When there are multiple reversals in the cash flows streams, the project could yield more than one IRR
• Not applicable where project involves cost minimization.

Comparisons of Methods

In general, the discounting cash flow methods (NPV & IRR) arrive at the same conclusions for competing proposals. But contradictory rankings may result in the following situations:

• Project lives of different duration
• The trend in cash flow of one project that is the reverse of that of another
• Future investment opportunities are expected to be different than at present and the investor knows whether they will be better or worse.

The major cause for different rankings of alternative projects under present value and internal rate of return methods is the varying assumptions regarding the reinvestment rate employed for discounting cash flows.

The NPV method assumes cash flows are reinvested at the cost of capital rate.

The IRR method assumes cash flows are reinvested at the internal rate.

The method that is best depends on which reinvestment rate is nearest the rate that the organization can earn on future cash flows from a project.

As a general rule, an organization should use the discount rate as its cost of capital.

The NPV method typically provides a correct ranking as the cost of capital is a more realistic reinvestment rate.

Management usually reviews the organization's required rate of return each year and may increase or decrease it, depending on the organization's current cost of capital.

The minimum rate of return for a proposal may be waived in a situation if the proposal:

• Has significant future benefits (research and development)
• Applies to a necessity program (safety requirement)
• Has qualitative benefit (product quality).

Payback:

• Helps evaluate a project's risk and liquidity
• Permits organizations with a cash problem to evaluate the turnover of scarce resources in order to recover invested funds earlier
• Has less possibility of loss from changes in economic conditions, obsolescence, and other unavoidable risks when the commitment is short term.

In rational decision-making, the primary objective in an investment is to maximize the corporate wealth of an organization.

An investment decision should not be influenced by any budget limitations or financing constraints.

This rationale should form the basis of any investment appraisal.

NPV or IRR are therefore more appropriate than the payback technique.

Payback can be used for preliminary screening where investment funds are exceptionally scarce. Projects should not be selected simply because the payback method indicates acceptance - the discounting methods should be used to justify and rank potential projects.