Investment Appraisal

Front 1

What’s payback method

Back 1

How long until we make our money back?” And that’s exactly what the method shows you, says Knight: “The time it takes for the cash flow from the project to return the original investment.

The shorter the payback period, the better. And it “obviously has to be shorter than the life of the project — otherwise there’s no reason to make the investment.” If there’s a long payback period, you’re probably not looking at a worthwhile investment.

The appeal of this method is that it’s easy to understand and relatively simple to calculate.

Front 2

Limitation of payback

Back 2

What you don’t know is how much of a total return it will give you over those three years.

This is the major limitation of the payback method. As Knight says, “It doesn’t tell you much. After all, you probably don’t just want to break even on your investment. You want to make money.” This can lead to some deceiving calculations.

Front 3

Why do companies use the payback method

Back 3

is to quickly check on the numbers before deciding whether to investigate the investment further.”

Payback is often used to talk about government projects or relatively risky projects that are capital intensive.

Front 4

Limitation of payback

Back 4

What you don’t know is how much of a total return it will give you over those three years.

This is the major limitation of the payback method. payback tells you nothing about the rate of return, which is a problem if your company requires proposed investments to pass a certain.” This can lead to some deceiving calculations.

2) One of the fundamental flaws in the method is you’re not taking into account the time value of money. The longer the projects go, the less likely they are to be accurate.

3) “Payback tells you when you will get your initial investment back, but it doesn’t take into account the fact that you don’t have your money for all that time,” he says. For that reason, net present value is often the preferred method.

3) After you’ve calculated it, and if your investment looks promising, it’s time to do a more rigorous analysis with one of the other ROI methods — breakeven, internal rate of return, or net present value.

Front 5

Where does NPV come from

Back 5

Most people know that money you have in hand now is more valuable than money you collect later on. Future money is also less valuable because inflation erodes its buying power. This is called the time value of money. But how exactly do you compare the value of money now with the value of money in the future? That is where net present value comes in.

Front 6

Where does NPV come from

Back 6

Most people know that money you have in hand now is more valuable than money you collect later on. Future money is also less valuable because inflation erodes its buying power. This is called the time value of money. But how exactly do you compare the value of money now with the value of money in the future? That is where net present value comes in.

Front 7

Def of pAyback period

Back 7

The time it takes for the cash flow from the project to return the original investment.”

Front 8

Where does NPV come from

Back 8

Most people know that money you have in hand now is more valuable than money you collect later on. Future money is also less valuable because inflation erodes its buying power. This is called the time value of money. But how exactly do you compare the value of money now with the value of money in the future? That is where net present value comes in.

Front 9

Def of pAyback period

Back 9

The time it takes for the cash flow from the project to return the original investment.”

Front 10

Def of NPV

Back 10

Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment.

In practical terms, it’s a method of calculating your return on investment

Front 11

Why do companies use NPV

Back 11

One, NPV considers the time value of money, translating future cash flows into today’s dollars. Two, it provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return.

Front 12

What happens if NPV is negative or positive

Back 12

If the NPV is negative, the project is not a good one. It will ultimately drain cash from the business. However, if it’s positive, the project should be accepted. The larger the positive number, the greater the benefit to the company.

Front 13

Limitations of NPV

Back 13

1) The first is that it can be hard to explain to others

2) The second thing managers need to keep in mind is that the calculation is based on several assumptions and estimates, which means there’s lots of room for erro

3) First, is the initial investment. Do you know what the project or expenditure is going to cost? If you’re buying a piece of equipment that has a clear price tag, there’s no risk. But if you’re upgrading your IT system and are making estimates about employee time and resources, the timeline of the project, and how much you’re going to pay outside vendors, the numbers can have great variance.

Second, there are risks related to the discount rate. You are using today’s rate and applying it to future returns so there’s a chance that say, in Year Three of the project, the interest rates will spike and the cost of your funds will go up. This would mean your returns for that year will be less valuable than you initially thought.

Third, and this is where Knight says people often make mistakes in estimating, you need to be relatively certain about the projected returns of your project. “Those projections tend to be optimistic because people want to do the project or they want to buy the equipment,” he says.